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How defaults can evolve

by SuperiorInvest

The United States is inching closer to disaster as lawmakers continue to wrangle over what it will take to raise the nation’s $31.4 trillion debt limit.

This has raised questions about what would happen if the United States does not raise its borrowing ceiling in time to avoid defaulting on its debt, along with how key players are preparing for that scenario and what would actually happen if the Treasury defaults your debts. creditors.

Such a situation would be unprecedented, so it’s hard to say for sure how it would turn out. But it’s not the first time investors and policymakers have had to ponder the “what if?” question and have been busy updating their playbooks on how they think things might play out this time around.

While negotiators are talking and appear to be moving toward a deal, time is running out and there is no certainty that the debt limit will be lifted before June 1, the earliest Treasury estimates the government will run out of cash to pay all its bills on time, known as “date X”.

Big questions remain, including what might happen in the markets, how the government plans to default and what will happen when the United States runs out of cash. Here’s a look at how things could play out.

Financial markets have become more jittery as the United States approaches X-date. This week, Fitch Ratings said it was putting the nation’s top credit rating of AAA on hold for a possible downgrade. Another rating company, DBRS Morningstar, did the same on Thursday.

For now, the Treasury is still selling debt and making payments to its creditors.

This helped to calm some fears that the Treasury would not be able to repay the full amount of the debt due, as opposed to just making an interest payment. This is because the government has a regular schedule of new Treasury auctions where it sells bonds to raise new cash. The auctions are timed so that the Treasury receives new borrowed cash at the same time as it repays its old debts.

That allows the Treasury to avoid adding too much to the $31.4 trillion debt — something it can’t do now because it took emergency measures after approaching the debt limit on Jan. 19. the cash it needs to avoid payment disruptions, at least for now.

This week, for example, the government sold two-year, five-year and seven-year bonds. But that debt won’t be “settled” — meaning the cash is delivered to the Treasury and the securities delivered to buyers at auction — until May 31, which coincides with the maturity of three other securities.

More specifically, the new cash borrowed is slightly more than the amount due. The Treasury borrowed $120 billion in three different notes this week. While roughly $150 billion of the debt is due on May 31, roughly $60 billion of that is held by the government from past crisis interventions in the market, meaning it will eventually pay off that portion of the debt itself, leaving an extra $30 billion. cash, according to analysts at TD Securities.

Some of that could go toward the $12 billion in interest payments the Treasury also has to pay that day. But as time goes on and the debt limit becomes harder to avoid, the Treasury Department may have to delay any incremental fundraising, as it did during the 2015 debt limit standoff.

The US Treasury pays its debts through a federal payment system called Fedwire. The big banks hold accounts with Fedwire, and the Treasury credits those accounts with payments on their debt. These banks then make payments through market plumbing services and through clearinghouses such as the Fixed Income Clearing Corporation, with the cash eventually landing in the accounts of holders from domestic pensioners to foreign central banks.

The Treasury could try to stave off default by extending the maturity of the debt due. Because of the way Fedwire is set up, in the unlikely event the Treasury decided to extend its debt maturity, it would have to do so no later than 10:00 p.m. the day before the debt was due, according to contingency plans. set by the Securities Industry and Financial Markets Association trade group, or SIFMA. The Group expects that if this happens, the maturity will be extended by only one day at a time.

Investors are more nervous that if the government runs out of its available cash, it could miss interest payments on its other debt. The first big test of this will come on June 15, when interest on bonds and notes with original maturities of more than a year will be due.

Moody’s rating agency said it was most concerned about June 15 as a possible day the government could go bankrupt. However, the corporate taxes flowing into her coffers next month may help her.

The Treasury cannot, under SIFMA, delay an interest payment without delay, but it could notify Fedwire by 7:30 a.m. that the payment would not be ready in the morning. He will then have until 16:30 to make the payment and avoid delays.

If you’re concerned about a default, SIFMA — along with representatives from Fedwire, banks and other industry players — plans to hold up to two calls the day before a default could occur and three more on the day the payment is due. with each call to a similar script, update, evaluate and plan what might develop.

“In terms of settlement, infrastructure and installation, I think we have a good idea of ​​what could happen,” said Rob Toomey, head of capital markets at SIFMA. “It’s about the best we can do.” As for the long-term consequences, we don’t know. What we’re trying to do is minimize disruption in what will be a disruptive situation.”

One big question is how the United States will determine whether it has actually defaulted on its debt.

There are two main ways in which the Treasury could default; not paying interest on your debt or defaulting on your loans when the full amount becomes due.

This led to speculation that the Treasury might prioritize payments to bondholders over other notes. If bondholders are paid but others are not, rating agencies are likely to conclude that the United States has avoided default.

But Treasury Secretary Janet L. Yellen suggested that any missed payment would essentially be a default.

Shai Akabas, director of economic policy at the Bipartisan Policy Center, said an early warning sign that a default is looming could come in the form of a failed Treasury auction. The Treasury will also closely monitor its spending and incoming tax revenue to anticipate when a missed payment might occur.

At that point, Mr. Akabas said, Ms. Yellen is likely to issue a warning with specific timing when she predicts the United States will not be able to make all of its payments on time and announce the contingency plans she intends. endeavor.

Investors will also receive updates through industry groups tracking key deadlines for the Treasury Department to notify Fedwire that it will not make the scheduled payment.

The default value would then trigger a cascade of potential problems.

Ratings firms said the missed payment would merit a downgrade of the U.S. debt — and Moody’s said it would not restore the AAA rating until the debt ceiling was no longer subject to political resistance.

International leaders have questioned whether the world should continue to tolerate repeated debt ceiling crises given the integral role the United States plays in the global economy. Central bankers, politicians and economists have warned that the default is likely to plunge America into recession, leading to second-order ripple effects from corporate bankruptcies to rising unemployment.

But these are just some of the risks known to lurk.

“These are all uncharted waters,” Mr. Akabas said. “There is no playbook to follow.

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