'Lehman Brothers 2.0': The Debt Ceiling's Worst-Case Scenario

If you're running low on apocalyptic visions, you can rent a copy of the Armageddon thriller 2012 -- or you can buy some popcorn and tune in to C-SPAN. Or, even better, you can find a copy of J.P. Morgan fixed-income strategist Terry Belton's new report, "The Domino Effect of a U.S. Technical Default." Belton describes in detail what would happen if Congress does not raise the debt ceiling. Think of this report as Wall Street's own Book of Revelation.

You've heard about this: For the past few weeks, lawmakers have been debating whether they should vote to raise the U.S. debt ceiling. (See Marketplace's explanations of the debt ceiling here and our news reports on what happens if the U.S. doesn't raise the debt ceiling here and here.)

The debt ceiling, as we've talked about before, is often talked about as the limit on how much the U.S. Treasury is allowed to borrow - like a credit limit on your credit card.

That's wrong.

The debt ceiling is more like Treasury's yearly shopping bill: it's an account of how much we, as a country, owe. And, typically, we owe much more than we have paid. So Congress has to raise the debt ceiling just so we can reflect the fact that we still carry a pretty big balance.

Some in Congress are now threatening to vote against raising the debt ceiling. This kind of talk reduces Stewards of Capital to sputtering outrage.

That may be why Belton has written his report: it moves the debate from vague threats to a sharply defined list of specific disasters. So what would happen if the debt ceiling isn't raised? Let's take a tour of that dystopian financial world, the way Belton has drawn the picture.

A scene from Michelangelo's Last Judgement. Tiziani Fabi/AFP/Getty Images

It's not default, it's delay: Treasury Secretary Timothy Geithner has said that the U.S. has until May 16 to raise the debt limit; then we'll run out of money and the U.S. will be in default. But J.P. Morgan's Belton says Congressional brinkmanship, waiting until the 11th hour, will spook investors who will start pulling back on their money as if the U.S. is in actual default. Belton says a long delay would cause "large systemic effects with long-term adverse consequences for Treasury finances and the US economy." That means that money market funds could "break the buck" again, as they did in 2008 - when they lost their stability and their net asset value was worth less than $1. Even if those funds don't break the buck, investors will run to claim their money, as they did in 2008 when large institutions withdrew $500 billion from money-market funds in the panic. He also predicts that foreign investors will be wary of trusting American bonds again. The market in which banks lend to each other would be completely shot. Belton says even a delay would be like a default on training wheels.

The markets would have no reliable collateral: Because Treasury bonds are so safe - almost like cash - banks and other financial institutions use them as collateral. If the U.S defaults, those firms will demand stronger collateral - which means they would say that Treasurys are worth less. If Treasurys are worth less, companies would have to reduce their debt and come up with more actual cash in other ways - so they would sell other securities, which would probably send the markets down.

Fear and Loathing in Treasurys - and a bigger deficit: In a default, Treasury would miss making a payment on the debt that investors already hold. If the Treasury misses this coupon payment - but also says it will make the payment as soon as the debt ceiling is raised - investors will still demand higher interest rates, Belton says. He found that foreign investors, in particular, would expect the Treasury to have to pay as much as half a percentage point more in interest - which could increase the federal budget deficit by $10 billion each year in the first few years, then $75 billion each year as our debt keeps piling up, according to his estimates. In a default, the U.S. GDP, which measures growth, would drop by about 1%, Belton predicts.

The housing market takes another hit: Belton predicts that mortgage rates could go up again. A lot of funds devoted solely to investing in real estate - called real estate investment trusts or REITS - use Treasury bonds as their main collateral. If they have to sell, they would send mortgage rates up again.

Over there, over there, spread the word over there : Foreign investors hold nearly half of Treasurys, and they are much less patient with our financial woes than U.S.-based investors. For instance, foreign investors fled from Fannie Mae and Freddie Mac investments even though the Treasury explicitly said it would support the two firms. Foreign investors now hold about half as much of the Fannie and Freddie debt they did in 2008.

The Summer of Our Discontent: There is a prediction market called InTrade where investors bet on the likelihood of political events. Right now, a significant number of InTrade's participants believe Congress won't raise the debt ceiling by July. If Congress doesn't raise the debt ceiling by then, it is likely that late June and early July could get really ugly as companies and banks try to raise additional cash, which Belton says may cause a run in the markets.

The Ghost of Christmas Future...and Christmas Past: Belton predicts that almost everything in the markets would be like a replay of the fall of 2008 - that dark time when Lehman Brothers fell and the entire U.S. system of credit nearly froze. He calls it "Lehman 2.0."

As far as I've seen, Belton is the only analyst to have taken a really close look at the consequences of a debt default. But there are people who disagree that we could descend into a Mad Max-style world of financiers dressed in rags.

Analyst Chris Whalen, the author of the book "Inflated," has argued for "the political power of fiscal sobriety." Whalen has said that the threat of default is a way to force Treasury investors to stop encouraging the government's profligate spending - that the U.S. is, in essence, getting too much credit for being a financially well-run country when it actually isn't.

At least now you know what another meltdown might look like. There's a significant trickle-down effect if all of this plays out as Belton suggests: One thing we did learn from the financial crisis is that banks will use any excuse to hold on to their money and not lend it out. So make sure you have all the mortgages and credit cards you need locked down now.

About the author

Heidi N. Moore is The Guardian's U.S. finance and economics editor. She was formerly the New York bureau chief and Wall Street correspondent for Marketplace.
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In rural Idaho, people already see the future and are preparing by food and water storage, guns and converting money into gold.
Unemployment is much worse than stated publicly.
About 1/3rd of local people have been unemployed for over 3 years; most are in their mid-50's. They are no longer counted as unemployed, simply because their unemployment benefits ran out. We are aware of the real numbers because they are our neighbors.

Buying guns and stockpiling food! What are the guns for? Typical numb headed tea partier who hates the fact that their is a "black" president!

Remember, in Bernank we trust! Always trust a bearded man (except when he's John Wayne Gacy of course).

I agree that the Republican Party is playing hardball with the Obama Administration. I am not as sure that Obama won’t cave in. Nevertheless, the Republican’s are playing a dangerous game because if Obama slips up and doesn’t catch the ball in time, it is the safety net of the Republican/conservative financial well-being that is likely to crumble, not the democratic/liberals who make up the majority of poor and middle class citizens of America. Today they no longer own a home or health care and they still can’t understand why. The truth is hidden behind endless inpenetrable walls of secrecy and deception.

I give President Obama my permission to let the economy hit bottom. From those ashes will arise a better situated middle class because, for one thing, they won’t owe that huge debt anymore. And when the democratic liberals start putting the pieces back together again, they will leave out the ruling elite — the global bankers who have raped the American public shamelessly. The Bush Crime Family, the War Corporations of America, the Skull and Bones banking conspirators. What is the work that they do? How do they contribute to us? We all know how we contribute to them. We pay through the nose. Indentured servitude.

Let the economy hit bottom. Financial anarchy does NOT require bloody violence. Financial treason sure didn’t.

When the economy hits bottom, it is not the poor nor the devastated middle class that is going to feel it — we are already down here at the bottom. It is the big guys, the banks, that will crumble now. LET THEM CRUMBLE. Then we will all see the smoke and mirrors trick for what it really is.

To hell with all the economic logarithms to try to comprehend/explain how “its complicated”. The reason why it is complicated is because we use terms that understate or fail to inform about what is really going on.

Follow the trail of the United States national debt to exactly whose hands each dollar lands in. Not the name of a law firm or corporate investment group. The actual name of each person to be paid. Who are these creditors? What are the person’s names that own the national debt — note by note. I don’t care if it is complicated, I want to know that answer and we have computers that can easily accomplish the task. So hand us over that information exactly: Who are we paying? What PERSON are we paying at that corporation? How does that PERSON distribute that money paid by our tax dollars? How many times do the same names repeat? If the payments are made to another country, what is the person’s name? Who gets the payments and how do those loan payments on our national debt get distributed?

What happens if the United States claims bankruptcy to the rest of the world, as Greece did? What if we are forced to agree to an austerity plan? Who is it really going to affect?

The middle class will still go to work, and they will still buy neccessities. They get by on supply and demand consumer/supplier relationships. They don’t need a government and they don’t need a ruling class to take every bit of cream away from the milk either.
On April 9, 2011 Belgium was in its 300th day of not having a government. They are doing fine. We can live without a government just fine. Police will continue to work, libraries will open, money will come from the local economy and natural lines of communication will allow life to continue as usual, especially because we are all using the same Internet.

We don’t need a judicial system. There is enough precedent cases worldwide to allow for nearly instantaneous data collection, integration, summary and recommendation for any crime that can be committed. We don’t need courts, lawyers, or judges. Using artificial intelligence will allow for the most fair, balanced and neutral decisions possible, even if a real magistrate must approve every AI generated conclusion and judgement. AI can check facts instantaneously. A court of law can be conducted by AI, with every objection entered or overruled without the need for excessive dependency on human flawed perception.

When the economy hits bottom, everyone should just keep doing their job to the best of their ability. Don’t worry and don’t fear. You will soon see, after the initial shock, that those people whose lives are completely superfluous to the every day lives of the masses, will have no support. They don’t deserve to live off of our sweat and tears, they have done nothing to earn it. We don't need to support their greedy and excessive lifestyles.

The world has my permission to let the economy hit bottom. We will survive and we will be happier.
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