Easy Street

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

Heidi Moore Apr 21, 2011
Easy Street

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

Heidi Moore Apr 21, 2011

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.

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