Banks Scrambled Before Possible Government Default
Business + Economy

Banks Scrambled Before Possible Government Default

Reuters/Eduardo Munoz

As the United States threatened to default on its debt last month, major U.S. banks set up war rooms, spent many millions of dollars on contingency planning and, in some cases, even prepared to underwrite federal government benefits.

In a series of interviews with top bank executives, new details emerged about the extent of the contingency planning that was undertaken before and during the 16-day government shutdown and as a potential default loomed.

Related:  Taxpayers Get Whopper of a Bill for Shutdown

The planning for worst-case scenarios didn't come cheap.

JPMorgan alone has spent more than $100 million on contingency planning for U.S. budget crises in recent years including this one, sources close to the bank say. It has reviewed and analyzed thousands of trading contracts, updated computer systems to handle fiscal emergencies, hired consultants, and built new models to figure out what might happen to securities prices.

It may not go to waste. The temporary budget agreement that President Obama signed shortly after midnight on October 17 to end the shutdown and lift the default threat, authorizes government spending through January 15 and eases enforcement of the debt limit until February 7, creating the potential for another budget crisis early next year, even as some Republicans vow they will avoid it. With each crisis, the once-unthinkable scenario of a U.S. default becomes a little more real, bank executives said.

"You could tell in the market that people were getting prepared much more this time for a potential default than last time," said a person involved with contingency planning at a major U.S. bank. "The threat moved the market, and people were preparing, whereas the first time there was little movement because most people didn't think it would happen."

The latest budget dust-up was the third in two years. In August 2011, fiscal battles led to the downgrade of the U.S. credit rating by Standard & Poor's, and then 16 months later, the discord resulted in across-the-board budget cuts at federal agencies known as "sequestration."

The "Right Thing to Do"
In October, officials at JPMorgan Chase & Co asked Chief Executive Jamie Dimon how to handle the government benefits that many of its customers receive monthly. Some of the bank's retail customers depend on government programs like Social Security and food stamps to pay their bills, and Dimon decided the bank would pay the benefits out of its own pocket if it had to. "We're going to fund them," he said, according to a person at the meeting. "It is the right thing to do."

Staff in the legal, finance and risk departments, were reluctant, and although they had to listen to Dimon, they found potential hurdles. The bank would have had to have paid an estimated $5 billion of cash every month, and it was not clear how the money could be legally recouped.

Related: How Congress Could Avoid Another Fiscal Crisis

JPMorgan's legal staff determined that, by law, customers' Social Security checks cannot be used as collateral for short-term loans. It was also unclear how regulators would assess the riskiness of the loans it was making.

Other banks gave their customers concessions because of the crisis in Washington. Wells Fargo, for example, waived late fees for those who were tardy with their mortgage payments in October.

The biggest question was how markets would have reacted to a default, bank executives said. It was entirely possible that panic could have spread across multiple assets, creating conditions as treacherous as in September 2008 when the collapse of Lehman Brothers touched off the worst of the financial crisis and the deepest recession since the Great Depression, Wall Street executives said.

However meticulous the planning, a panic is almost impossible to guard against, top bankers said. And even if there is no default, the threat of one is bad news for Treasury debt. U.S. government bills, notes, and bonds are seen as assets without credit risk that form the basis for pricing securities globally, and every time a default looms, that status is threatened, said an executive at Goldman Sachs Group Inc.

Many Unknowns
Executives said that preparing for a default was difficult, because there were so many unknowns. No one was sure what the value of defaulted bonds would be if the government really had failed to make payments. Those questions could have hurt trading in multiple markets, which in turn raised questions about how the Federal Reserve might intervene.

Bankers characterized their conversations with the Fed as "one-sided," with many of their questions remaining unanswered. The central bank apparently did not want to give traders in financial markets the impression that everything would be fine if the debt limit were not raised.

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But banks still spent a lot of time considering the Fed's options. The central bank, for example, could have directed its quantitative easing bond purchases toward buying more Treasuries, or defaulted Treasuries. It could have provided financing for defaulted Treasuries through participating in the repo markets. A spokesman for the Federal Reserve Bank of New York declined to comment.

When Lehman failed, commercial paper markets seized up, and the government had to guarantee it. Without that intervention, corporations could have been starved for cash and unable to pay employees. If the central bank was concerned about similar market issues in this fiscal crisis, it could have bought short-term debt known as "commercial paper" from companies. The Federal Reserve looked closely in the runup to this October's default threat at the "repurchase market," or "repo markets," where investors can finance their Treasuries.

Goldman's operations staff spent hours on the phone with clients whose Treasury collateral would mature in late October and early November, asking whether they wanted to try to sell these securities, or trade them for newly issued Treasuries.

At Morgan Stanley, daily calls were held among Treasury-bond traders, those handling repurchase agreements and operations staff. At JPMorgan, senior executives and relevant personnel met every day to figure out how the bank would deal with possible issues that could arise, said people close to the bank. The problems associated with defaulted debt extended beyond market turmoil, into the plumbing of markets, an area banks focused on.

"We've figured out what to do with systems on defaulted securities, what would happen with impaired securities, and how the market would clear, settle, and finance those assets," said one executive at Morgan Stanley involved with the planning process. He added that this planning would reduce the operational and market problems that would arise from delayed Treasury payments, but would not eliminate them.

Much of the work involving market protocols was orchestrated by the U.S. Securities Industry and Financial Markets Association, a trade group. SIFMA's presumption was that any Treasury due to mature would have its maturity extended one day at a time.

Extending maturities creates a complication for banks' bond payment systems, which run nightly and determine which bond issuers will pay interest on securities the bank owns the next day, said the Morgan Stanley executive. If the government defaulted, a security due to mature would have to be removed from the broader system and handled manually. If the crisis had worn on and there were 300 or 400 defaulted securities, managing them manually could have been cumbersome, the person said.

On the consumer side, JPMorgan also looked at how to handle credit card payments due from government employees. The bank was inclined to forbear on these obligations, but had to change its systems to ensure they would not automatically report delayed payments to credit agencies. It was also ready to add extra cash to its automated teller machines in case panicky consumers tried to take out as much money as they could get their hands on.

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