How a Default Could Devastate the Country
Policy + Politics

How a Default Could Devastate the Country

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As negotiations over a major deficit reduction package appear to be going nowhere over the weekend, federal and state officials, financial and corporate executives, and average investors and consumers suddenly face the very real threat of the first-ever defaulton U.S. debt, a possibility that once seemed unthinkable.

President Obama signaled late Friday that the government was preparing for the worst if he and House Speaker John Boehner, R-Ohio, fail to reach agreement before August 2, when the Treasury begins running out of money to pay creditors and meet other obligations. “If we default, then we're going to have to make adjustments,” Obama told reporters at the White House.

Among the growing signs that the U.S. is bracing for the possibility of default:

*  Treasury Secretary Timothy Geithner and Federal Reserve Board Chairman Ben Bernanke met Friday for 90 minutes to begin contingency plans for preventing a default  from triggering a calamitous ripple effect through the economy – which could send stocks tumbling to financial crisis levels of three years ago, strip major banks of essential liquidity and touch off an international financial crisis. The administration has also begun discussing how best to prioritize expenditures of revenues once the Treasury exhausts its borrowing authority, such as whether payments to creditors like China and Japan should  take precedence over sending out Social Security checks or paying the military.

*  Maryland and Virginia, home to large numbers of federal workers and government contractors, were put on notice by Moody’s last week that their credit ratings may be downgraded if the federal government is forced to lay off tens of thousands of workers and postpone paying contractors in the event of default. Experts say the government would have to almost immediately cut spending by 40 percent when the Treasury exhausts its borrowing authority early next month.

* Nationwide, consumers and financial advisers pondered the effects of another possible stock market crash that could decimate 401(k) retirement funds, push up interest rates on mortgages and car loans, throw more people out of work and possibly send the fragile economy back into a recession.

“It’s conceivable the worst-case scenario is that the entire financial system of the world just freezes up, and it will make what happened with Lehman Brothers look much less by comparison,” Bruce Bartlett, a former Reagan White House policy adviser and columnist for The Fiscal Times, said on Saturday.

Geithner, Bernanke and Federal Reserve Bank of New York President William Dudley said in a joint statement Friday that while they’ve begun discussing the implications for the U.S. economy, they “remain confident that Congress will raise the debt ceiling soon.”

Emergency Meeting – and Credit Rating Worries
On Saturday morning President Obama met with top congressional leaders at the White House for 50 minutes to discuss a possible deal on a deficit reduction package, after Boehner announced Friday night he was abandoning talks with Obama. Boehner attended the Saturday meeting, but said he intends to work now with House and Senate leaders to forge a bipartisan plan. Boehner said he wants a framework in place by Sunday afternoon.

Senator Harry Reid, for his part, on Saturday night referred to Republican “intransigence” and said, “We have run out of time for politics. Now is the time for cooperation.”

For most Americans, the debt ceiling up until now has been mostly an abstraction. Since Congress enacted debt ceiling legislation during World War I, lawmakers and the White House have agreed 74 times to increase the Treasury’s borrowing authority to cover interest and principal and other government costs not covered by tax revenue.

The U.S. government’s AAA credit rating is considered the gold standard worldwide – and the benchmark for all other borrowing – which explains why the Treasury is able to borrow trillions of dollars but pay only miniscule, bargain-basement interest rates in return. But since early this year, Obama, Geithner and Bernanke have warned of  “catastrophic” economic consequences if Congress fails to permit the Treasury to continue borrowing beyond August 2.

All three major credit rating services – Fitch, Standard & Poor’s and Moody’s Investor Services – have said the government’s top rating would be in peril in the event of default. Some experts say the Treasury may still be able to borrow for a few days beyond August 2. But the administration, for now, isn’t counting on that. If Congress fails to raise the debt ceiling, the Treasury would have enough in tax revenues to cover the interest on Treasury securities, as well as other social safety net programs including Social Security, Medicare, Medicaid and unemployment insurance, according to a Bipartisan Policy Center study.

But the administration would have to decide how to use the remaining revenues to cover the government’s general operating costs or pay government vendors. With a projected $306.7 billion of obligations throughout August but only $172.4 billion of revenue coming in, the administration would have to cut spending by 40 percent almost immediately, according to the study. Whether to pay government employees and active duty troops, fully fund the Justice Department and FBI and keep the doors open at the Departments of Health and Human Services, Education and Housing and Urban Development – all of this, and much more, would need to be decided. 

Key Concern for Regulators
The Wall Street Journal  reported Saturday that regulators’ key concern is Treasury’s expected move to replace $87 billion in maturing debt on August 4. Investors are still expected to take part in the bond auction, but the government might have to pay more if the debt ceiling isn’t raised.

Another big concern about a default is the potential impact on the massive tri-party repo market, in which securities dealers find short-term funding from investors for a substantial portion of their own and their clients’ bond holdings. The  repo market is critical to maintaining liquidity for banks, securities firms and money market mutual funds. Its disruption during the financial crisis of 2007 to 2009 contributed to the failures and near failures of Countrywide Securities, Bear Stearns and Lehman Brothers.

“If all the people providing money into this [repo market] look up and say, ‘I don’t want to do this anymore,’ then the whole system breaks down,” explained a former Treasury official on Saturday. “All of a sudden, you have a bunch of financial institutions that lose funding for what are very large liquid assets. That’s scary.”

“You could see a cascading effect that makes the European problem much worse, and that in turn means a global economic set back of strong proportions,” added Norman Ornstein of the American Enterprise Institute. “We’re playing with fire, dynamite here.”

States Already Feeling Pinch
Last week Moody’s warned that five out of the 15 Triple-A rated states are at risk if the federal government’s bond rating is downgraded. The five states are Virginia, Maryland, Tennessee, New Mexico and South Carolina, all highly dependent on bonds. Moody’s also said it would downgrade at least 7,000 top-rated municipal credits and $130 billion in municipal debt directly linked to the U.S. Also cited by Moody’s for review are mortgage-backed bonds secured by the federal government and agencies such as Fannie Mae and Freddie Mac.

Maryland postponed a bond sale that had been scheduled for last Friday, after the Moody’s warning. California, which issues short-term bonds this time of year, is working to arrange bank loans instead, citing market uncertainty.

Virginia Governor Bob McDonnell, a Republican, expressed his outrage over Moody’s warning. “Yeah, I'm very unhappy. In fact, I'm furious,” he said at a news conference last week. McDonnell has written to Obama and Congress urging a quick solution to the deficit problem.

A default could also raise borrowing costs on state municipal debt, which finances new schools, roads and bridges and other capital projects such as utilities, water systems and hospitals. Historically, municipal bond interest rates have been tied closely to Treasury securities. Even if a deficit reduction package is reached, it might include significant cuts to federal Medicaid spending, which would also shift significant program costs to states at a time when they can least afford it, according to Moody’s Analytics.

“If the government stopped paying federal workers or held back Social Security checks, the resulting loss of individual income could have a profound effect on state and local tax revenues,” according to a report from the Pew Center for the States.

The National Conference of State Legislatures told members last week that states would likely have to tap their own revenues to maintain spending for a wide variety of state-federal programs – or decide which programs might cease temporarily. State governments rely on the federal government for 25 to 50 percent of revenue.

Investors and Consumers Would Suffer
For all the fuss in Washington, Wall Street’s relative calm until now suggests the markets remain optimistic that Obama and Congress can hash out a deal. The optimism is not without some merit. Of the 74 times the U.S. has raised the debt ceiling, the country has never gotten this close to default, said Bruce Bartlett. “We’re in unknown territory.”

Still, some economists worry that as the deadline approaches and talks continue to stall, Wall Street is on the verge of a major collapse similar to 2008, when the Dow plunged 700 points after Congress failed to pass Troubled Asset Relief Program, or TARP, forcing Congress to go back and subsequently approve it.

The markets’ ability to look beyond the political logjam could, in fact, be its undoing. “If there is a default, it will take everybody in the markets totally by surprise,” said Bruce Bartlett. So “the reaction will be much more severe than it would be if this was something that was widely anticipated and people had prepared for.”

The firm Macroeconomic Advisers estimated that if action to raise the debt ceiling is delayed one month, Treasury debt would be downgraded, interest rates would rise modestly, and the economy would enter a brief recession. Stock prices would also temporarily decline by roughly 5 percent, on par with the Dow’s drop in 2008.

Lance Roberts, CEO of Streettalk Advisors, an investment management company, said a potential default could lead to a collapse in the stock market’s overall value by 50 percent, impacting 401(k) plans and personal savings accounts. Additionally, commodities would likely decrease, and foreign investors would almost immediately cease investing capital in the U.S.

These actions would also impact consumers, whose interest rates on credit cards and home mortgages would soar, adds Roberts. Prices at the pump would skyrocket, and retail sales would rise. Roberts expects small business to start shutting down at an alarming rate, loan products to dry up, and jobs to be lost.

“We’ve learned in the last couple of years how deeply interconnected financial markets are,” said Bruce Bartlett.