The Econometrix

Republicans toy with allowing debt default

If we have a Debt Ceiling Crisis, what will trigger it?  What kind of uncertainty will cause the whole world to decide to dump Treasuries? Cause interest rates on Treasuries to rise very suddenly as successive waves of investors decide that holding Treasuries isn’t so “safe” after all?  The downside risk of holding Treasuries then becomes a self-fulfilling prophesy.   

Right now, I’m leaning toward a bad Treasury auction as the trigger.  If large holders of Treasuries let their holdings run off without replacing them, then at some point a number of big buyers that usually show up, just won't there one time.

But there are many other possibilities.

• A “cut off my nose to spite my face” speech on the House floor. 
• Yet another failed debt ceiling vote.
• Treasury admitting that their calculated date to run out of money was overly optimistic.
• Another downgrade warning, or a downgrade.  If the ratings agencies were being honest with themselves, we have higher sovereign risk, right now, than the cut-off for AAA.  However, the big three would under so much pressure not to issue a downgrade it is hard to imagine anything other than a warning.
• A portfolio document of a major bond-holding financial institution indicating a substantial decline in holdings of US Treasuries.
• A very bad quarterly announcement from one of the entities that borrows through Treasury, such as Fannie, Freddie, FDIC. 
• A side effect of the QE2 wind-down starting in June.
• The sudden realization that if a major financial institution is wobbly, Treasury can do nothing to save it.
• Some firm or country selling Treasuries to raise cash for an unrelated activity. For example, if there were some new large-scale disaster, either domestic or foreign, like the earthquake in Japan.

I think the analogy of a game of chicken is the wrong one.  It assumes that the players know at what moment they can swerve and still survive.  That assumes essentially that you know how long you have with absolute certainty.  I think the better analogy is a game of Russian Roulette.  You don’t know how many more times the trigger can be pulled before the badness happens, but you know it is less than six.

One of the things we know about financial crises, is that they never happen precisely when you think they will.  When there is a fixed point in the future when some entity is scheduled to run out of money, people start making sure that their demand for cash happens before everyone else’s.   This is the basis of a classic bank run.  Cash starts evaporating from the coffers at an ever increasing rate, as people maneuver to position themselves for the eventual turning off of the spigot.

Therefore, I think that the U.S. Treasury has an incredibly optimistic forecast of how long they can push money around and still pay their bills. 

How can people adjust?

• Well, contractor billing cycles will drop from 60-90 days to 30 days.
• Government agencies will try to fill up their rainy-day funds, because the photocopier repairman won’t show up if no one knows when he’ll get paid.
•  If you are a doctor with a large clientele of Medicare or Medicaid patients you will pay your billing clerk overtime to catch up on billing. 
• If you are a money market fund manager you may let some of your Treasury bills and bonds run off and not replace them, leading to a creeping increase in the interest rates that Treasury pays at every auction. 
• Foreign investors may also not reinvest the proceeds of expiring Treasuries, and may actually sell them.

Every one of those adjustments will have an effect on the rate at which Treasury burns through money.

Thus, it isn’t even necessary to have a ratings downgrade to have interest rates adjust.  And once the “risk-free” rate of interest is no longer perceived as “risk-free”, it will never go back.  We will pay a well-congress-can-be-idiots risk premium forever.

The markets first fell and then rebounded on this news that the S&P had changed their outlook on the US government bonds from “stable” to “negative”. 

It is easy to understand why the stock market might fall and bond market might react by increasing interest rates.  What is odd is that they both reversed course. 

I believe that the markets did this because by warning that there could be a downgrade, because of the chance of a technical default, actually decreased the chances of a technical default occurring. 

Standard & Poor’s credit analyst Nikola G. Swann said, “The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”

The Republican leadership, largely in response to the demands of the Tea-party/gold-bug wing of the party, had been saying that the negotiations on the debt ceiling would only happen after the debt ceiling had been reached, which is expected to be on May 16^th.  Treasury can use some fancy accounting, and move money around, so as to not default until about July 8^th.   So McConnell’s statement that, ``we anticipate that this debt ceiling issue will come before us between Memorial Day (May 30) and the Fourth of July,'' is frankly horrifying.   Given that, with that small a margin of error, any screw-up could lead to a technical default, I think that S&P were completely within their rights to downgrade, rather than just warn.

I sincerely hope that this warning by S&P has caused the Republicans to rethink their strategy of brinksmanship.  Even raising the specter of a default is costly.

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What do you think the probability of political intransigence leading to technical default is?

Bond ratings and probabilities of default:      

AAA: almost zero default probability
AA: very low probability (less than 0.1%)
A: low probability of default (about 0.15%)
BBB: low/medium probability of default (lowest investment grade) (about 0.3%)
BB: medium probability of default (about 1.2%)
B: high probability of default (about 3.5%)
C: very high, about 13% probability of default.