Could Financial Markets Handle a US Debt Default?

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Published: Thursday, 17 Jan 2013 | 12:41 PM ET
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A failure to make payments on U.S. Treasurys, 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, according to analysts and investors.


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But that doesn't mean investors would necessarily run to the safety of Treasurys. 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.



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.

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The likelihood of a default on U.S. Treasurys 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, Treasurys have no grace period to make up for missed interest or principal payments.


Many banks and investors may not even have the systems needed to screen out which Treasurys have principal or interest payments due that are most at risk of not being paid.



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Interconnection and Contagion



One potential problem is that the New York Fed's Fedwire Securities Service, which is used to hold, transfer and settle Treasurys, would need some manual daily adjustments, as it otherwise can't transfer bonds that are past their maturity date, the group said in meeting minutes from last year. Other systems may have similar problems, it said.



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After the September 2001 attacks on the World Trade Center and the Pentagon, market participants struggled to identify who their counterparties were in the repo market, and even had difficulty grasping whether their net Treasurys position was a long or short one, after trading records were destroyed.

The number of trade "fails," when the borrower doesn't supply Treasurys to settle a loan, surged in the weeks after the attacks, initially rising because of operational problems and then staying high as the cost of obtaining Treasurys to settle a loan was as expensive as the cost of allowing a fail.



After that, back-office errors at the Treasury caused the government to be late in redeeming three series of Treasurys bills, according to an academic paper by Terry Zivney and Richard Marcus published in the Financial Review in 1989. The failure caused rates to rise, and the government faced lawsuits from investors hurt by the delays in repaying the bonds, they said.

Markets now are far more complicated. Battles over ownership, interest paid or owed and a host of other issues relating to the transfer of the securities would likely be mired in legal disputes. U.S. debt is also considerably higher, and there is greater foreign ownership of Treasurys. The economy is also more vulnerable, making the risk of a creditor exodus a far more damaging prospect for the country.


That would leave the U.S. struggling to refinance more than $4.6 trillion that come due within two years, including $3 trillion of Treasurys due to mature in 2013.

While the stigma of a U.S. debt default would be damaging enough to investor sentiment, the chaos from a breakdown in financial markets' systems that might result would be even scarier.