Technical Default, Treasurys And Repo

The Debt Ceiling debate is upon us once again. GC Repo rates have moved higher, there’s been a sell-off in short-term Treasurys, and cash investors began pulling cash from the Repo market. The key point here is that only Treasurys which are about to mature or make coupon payments are affected. Right now, that means the weekly bills maturing beginning on October 24, and any Treasurys maturing or paying a coupon on October 31, November 15 and potentially November 30. In the realm of the current debate, those are the securities in play. A technical default does not affect other Treasurys, if it does, it’s indirectly. Understanding a technical Treasury default is important in the game right now.

For a history of the debt ceiling crisis, please take a look at my “The Debt Ceiling, Treasurys and Repo” article from January 15, 2013.

Cross-Default

There is not cross-default in U.S. Treasurys because the Treasury never included such a provision in its Uniform Offering Circular. If one Treasury misses a payment or is not fully paid at maturity, it doesn’t, technically, affect other Treasurys. That’s why you see only the prices of very short-term Treasurys affected – those which are close to maturity dates.

Not A “Lehman” Crisis

Let’s be clear, there’s no way the Treasury market or Repo market is going to become “inoperable.” Just because 1 month Treasurys trade at higher yields than 1 month CDs doesn’t meant all Treasurys are a lower credit quality than banks, just look how 3 month Treasurys are still trading at .08%. Believe me, I’ve seen the market come close to inoperable: September/October 2008, September 2001, and slightly inoperable: August 15, 2003 blackout, LTCM in October 1998, and a variety of year-ends. Yes, there will be rate volatility, some cash will flee the market, there will be dislocation, but this is not an event which will shut down the market. In the grand scheme of overnight rates, we’ve seen a year-ends with 1,000+ basis point moves. Up and down 50 basis points for very short-term paper does not a crisis make.

The bottom line is that there’s a fear-factor being peddled. There’s political posturing to make the crisis appear worse than it would be. So far, I believe politicians have been somewhat irresponsible, creating more public anxiety than is warranted. There’s no reason to tell horror stories of doom and gloom to try to scare people.

Timing

First off, October 17 is not the date when the Treasury runs out of cash. October 17 is the date when the Treasury is unable to continue borrowing funds, meaning it reach its $16.7 trillion debt limit. There’s still cash on hand, tax revenue coming in, and the ability to move accounts around to avoid issuing new Treasurys. In fact, as of last Thursday, there was about $36.5 billion of cash at the Treasury. The CBO estimates the Treasury will run out of funds in about “one or two weeks.” Wrightson put the drop-dead date at October 31 or November 1. As someone who’s followed Fed watching for a number of years, I’ll go with Wrightson.

Remember, when the Treasury officials give doom and gloom dates, it’s because they’re supposed to. They absolutely have contingency plans to extend the debt limit breach further than they’ll admit. In the past, Treasury Secretaries have never announced their contingency plans. If you can remember back to 1995, Treasury Secretary Robert Rubin kept “finding” new money and accounts to juggle to keep the payments flowing.

Technical Default

Here’s an important part about the “technical default.” It’s not whether investors get their money back, it’s a matter of when. Certainly, it’s a bad precedent for Treasurys to miss a payment and it will affect the liquidity premium of Treasurys in the future. However, when a Treasury misses a coupon payment, the holder on the payment date will have a money-wire fail from the Treasury. The next day, that Treasury continues to accrue interest for the next coupon period, so the missed payment should only affect the Treasury holder on that record date, and not going forward. The missed payments will get paid back immediately when a new debt deal made. So, in the end, it’s a matter of how much time the investor must wait before getting paid back, and some uncertainty during that wait.

Remember again, the technical default only affects Treasurys maturing or paying coupons over the next few weeks.

There are also questions as to which investors and organizations are allowed to hold defaulted Treasurys; some will and some won’t. It’s whether missed payment Treasurys can be pledged at an exchange, clearing bank, in customer Seg funds, given to Repo cash investors, or central clearing counterparties. The biggest question is whether the Fed can accept defaulted Treasurys as collateral. Since the idea of Treasurys defaulting has always been considered impossible, we’ll have to look for announcements over the coming days from each organization.

Money Funds

Last week, rumors started to fly around the market that money market funds and other short-term investors were getting nervous. During the last debt ceiling crisis, July/August 2011, these funds were caught surprised. This time, many of them want to be better prepared. Blackrock, Fidelity, JP Morgan have all publicly announced that they have no exposure to any Treasurys potentially affected by the debt ceiling crisis; meaning they sold everything in the very short-term, which is one reason why short-term Treasury yields shot higher. However, Federated announced that they’re sticking with their short-term Treasury positions, confident that the crisis will be resolved. Evidently, SEC Rule 2a-7, that governs money market funds, does not prohibit them from owning securities in default. There’s an important difference here this time around – money funds are preparing for the crisis, as opposed to being caught surprised like in July/August 2011.

The funds still have another issue to worry about – public fear about a Treasury debt default. Money funds dedicated exclusively to U.S. Treasurys have seen $7.4 billion in redemptions last week, which is similar to the $9.4 billion withdrawn before the last debt ceiling crisis. Overall, during the last crisis, money funds lost about 10% of their assets to redemptions.

Repo Market

Back in July/August 2011, general collateral Repo rates shot up as investors pulled cash from the Repo market. Cash investors don’t want to be stuck with Treasurys in tri-party accounts which mature or pay a coupon. Whomever is holding the U.S. Treasury in their account on the coupon payment or maturity date is the one who misses the payment. That’s the risk in the Repo market. Coupon payments between Repo counterparties are governed by the Master Repurchase Agreement, so whether or not the Treasury pays, the Repo counterparties must still pay. I also heard some cash investors have closed down their tri-party accounts and switched to deliverable Repo trades only. Would the Street really dump maturing or coupons paying securities on their unsuspecting customers?

By now, Treasury GC Repo rates have already moved higher as cash investors pull some cash out of the out of the market.

Interestingly, as the GC Repo rate moves higher, the amount of Fixed-Rate Reverse-Repo (FRRP) activity at the Fed usually declines. Why borrow Treasurys from the Fed at .01% when the market rate is substantially higher? However, as the debt ceiling crisis grew on Thursday and Friday, so did cash investor FRRP activity with the Fed. There was $425 million in FRRP with the Fed on Wednesday, on Thursday and Friday that number increased to $1.997 billion and $1.421 billion, respectively.

What’s next for the Repo market? If cash investors continue to worry about receiving defaulted securities as collateral, more money will leave the market and Repo rates will continue to go higher. However, there’s another possibility too: perhaps Repo rates for Agencys and Agency mortgages will invert to Treasurys. That is, if there’s enough angst about Treasury Repo collateral, cash investors can get AAA-rated, U.S. government owned Federal Agencys as collateral instead. Cash moving from Treasury collateral into Agency collateral will push the Agency Repo rate below the Treasury Repo rate. The irony would be that investors would be fleeing Treasurys for Fannie and Freddie paper, which nearly defaulted five years ago, because they believe Agencys are safer collateral than U.S. governments – when US government owns the Agencys in the first place. Kind of funny.

Debt Ceiling Extension

What happens if a compromise is reached and the debt ceiling is extended? It saves the securities in the short-end for now, but it still puts securities paying coupon or maturing after the extension date at risk. So, if we’re worried about Treasurys maturing October 31, November 15 and November 30 now and the debt ceiling is extended for 4 months, we’ll be back doing the same fire-drill for February 28, March 15, and March 31.

What Can You Do?

Primary Dealers have access to the Fed’s SOMA Securities Lending program and can swap general collateral for specials at a fee of 5 basis points. Primaries should have to ability to swap the technically defaulted issues for other Treasurys easily at the Fed. Assuming each Primary Dealer can access the Securities Lending program for $5 billion each and there are 21 Primaries, that’s $105 billion of technically defaulted Treasurys that can be taken out of the market and parked at the Fed.

For coupon paying securities, one solution is to STRIP them. Any Treasurys paying coupon on October 31, November 15 or November 30 can be stripped into the separate coupon and principal components. A Primary Dealer sends the bond into the Fed and receives back the separate coupon payments and principal payments later that day. The first coupon payment, the one that’s potentially going to be missed will not affect the other coupon payments and principal for that bond. The first coupon payment can then be sold to someone else. It might trade like a 1 month T-bill, at a higher market rate to reflect the delay in payment. After the missed coupon payment date, the bond can be “reconstituted” back at the Fed, putting the bond’s pieces back together and the original bond is new again, though technically marred by a missed payment. Or, the investor can just hold the separate coupon and principal payments, which are acceptable Treasury collateral where the whole Treasury bond or note may not be.

What Can The Treasury/Fed Do?

Of course, the best solution is a political compromise. Short of that, my suggestions here come down to slight-of-hand and accounting moves. Maneuvers designed to work within the Fed’s and Treasury’s legal framework. Here are some creative, yet temporary solutions:

1. Keep Accruing Interest – The Treasury can announce that Treasurys close to scheduled coupon payment dates will keep accruing coupon interest until the next payment date and make a double coupon payment then.
2. The Fed could use the QE purchase program to buy the short-end Treasurys which are very close to maturity. The Fed is authorized by the FOMC to buy $85 billion a month. If the Treasury is close to not paying a maturing Treasury, the Fed could buy it and take it out of the market.
   
3. The Fed could allow an expanded use of Repo transactions (counterparties deliver Treasurys to the Fed and receive cash in return). Market participants could submit maturing and coupon paying securities to the Fed the day before the payments are supposed to be made. When the payment is missed, the Treasury owes the payment to the Fed. “Customers” could be able to submit their securities into this facility through Primary Dealers, like they do for a Treasury auction.