Analysis: Preparing for the unthinkable: Could markets handle a U.S. default?

Thu Jan 17, 2013 12:56pm EST
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By Karen Brettell

NEW YORK (Reuters) - Squabbling in Washington over the debt ceiling is again raising the specter that the United States may be forced to delay payments on its debt. While the stigma of a default would be damaging enough to investor sentiment, the chaos from a breakdown in financial markets' systems that might result would be even scarier.

A failure to make payments on U.S. Treasuries, however brief, would create widespread damage in short-term funding markets, which are crucial to daily operations of financial institutions, investment firms and many corporations, said analysts and investors.

In the event of a default, confusion would be rampant as trading systems struggle to identify, transfer and settle bonds that have matured but have not been repaid. Interest rates would surge and investors would likely sell stocks and commodities as they fled risky assets, analysts said.

But that doesn't mean investors would necessarily run to the safety of Treasuries. Many U.S. government bonds could be shunned as investors worry about which issues are in default - even longer-dated issues that could have a coupon payment due that would potentially be in jeopardy.

A default could also trigger a wider paralysis in the financial system that could quite quickly stall the economy, as happened at the height of the financial crisis in September 2008.

For starters, money market funds are not allowed to hold defaulted collateral. These funds pulled back on making loans in 2011, when the ceiling was last an issue, and some analysts fear this time could be worse, potentially creating broad funding problems and send the cost of borrowing in short-term markets, including those in repurchase agreements or loans based on Libor - surging.

The U.S. Treasury hit its $16.4 trillion debt ceiling - the legal amount it is allowed to borrow - on New Year's Eve. The Treasury Department will run short of funds as early as mid-February, so legislation is needed to increase the borrowing limit. This had been a formality for years but turned into a political standoff between congressional Republicans and the White House over government spending levels in the summer of 2011. The resulting battle roiled markets concerned about U.S. political gridlock and its impact on the economy.

The likelihood of a default on U.S. Treasuries has in the past been seen as so low that many parts of the market fail to even account for it in planning and paperwork. For example, unlike other debt, such as corporate bonds, Treasuries documentation has no grace period to make up for missed interest or principal payments.   Continued...

A man is silhouetted in an electronic board showing the FTSE MIB Index for the Italian equity market in this photo illustration taken in Rome August 9, 2011. REUTERS/Tony Gentile