The first salvo of the next Debt Ceiling Crisis was shot across the bows of Congress last Wednesday when Treasury Secretary Jack Lew sent a letter to Congress warning them that the government could run out of money by late February. Officially, the Treasury’s borrowing authority runs out on February 7, but there’s one thing that’s always true about a debt ceiling crisis: the Treasury Secretary under-estimates how long the government can function using “extraordinary measures.” That’s the ability of the Treasury to move funds between government accounts to fund the government for a short period of time, like diverting funds from government employee pension fund accounts.
There’s actually another thing that’s always true about a debt ceiling crisis: it sneaks up on the market. The market goes from mildly pricing some volatility to outright panic. The One Month T-Bill rate jumped last week from a yield of 1 basis point to 5 basis points, representing what many in the Treasury market already know – if there is a debt ceiling crisis and there’s a chance the U.S. Treasury might miss a payment, it’s the shortest maturities of Treasurys which are affected. That is: T-Bills, short coupons, and notes and bonds with coupon payments during the time in question. Let me be clear – it’s all about missing a maturity or missing a coupon payment on the shortest Treasurys.
In reaction to the possibility of missed maturities and coupon payments, money market funds, corporate treasurers, central banks, and other portfolios begin selling short-term Treasurys, putting upward pressure on rates. In the Repo market, cash investors become worried that they’ll receive a maturing or coupon paying Treasury as collateral. Some cash investors exit the Repo market, which puts upward pressure on Repo rates.
Debt Ceiling Crisis I – July/August 2011
The first debt ceiling crisis occurred in July and August 2011 and it was somewhat unique; it was the first time there was a serious threat of missed payments so we were in new territory. The “crisis” part for short-term yields, including Repo rates, lasted about three days. We learned a lot of things about the crisis’s impact on the market: investors sold short-term Treasurys, sold coupon paying Treasurys, and investors pulled cash out of the Repo market, preferring to leave the cash in their clearing account.
For more information, see my article, “The Debt Ceiling: Treasurys And Repo.”
Debt Ceiling Crisis II – October 2013
Back in October, the “crisis” part lasted a little longer; about six days in total. As we approached the last day of borrowing authority, even before the extraordinary measures kicked in, there were cries about the entire U.S. Treasury market defaulting and the ensuing panic. Many were anxious that there would be a full blown debt default which would lead to a global financial crisis. But in reality, a technical default wasn’t even pending for weeks. At the time, Traders began to speculate as to how technically defaulted Treasurys would trade, but there were no clear answers. The cries of panic spooked politicians enough to extract a political deal.
For more information, please see “Technical Default: Treasurys And Repo.”
Debt Ceiling Crisis III (?)
ICAP Wrightson estimates that the Treasury will mostly likely run out of cash during the second week of March. Naturally, if the Treasury could make it to April 15, additional tax revenues will push back the debt debate for months. Right now, that appears very unlikely. If the market follows a similar pattern this time around, T-Bill rates and Repo rates will spike right before the borrowing authority ends on February 7, beginning next week, even though there is no fundamental risk of default for another month.
And if there was a technical default, would it be catastrophic?
Technically Defaulted Treasurys
Net government debt payments are about $50 billion a month and monthly government revenue is around $250 billion a month. Overall, the interest on the national debt is only about 15% of overall government spending. So let me be blunt, there’s enough revenue to pay the interest and the maturing Treasurys.
But let’s say the Treasury doesn’t have enough money to pay for maturing Treasurys and make coupon payments, what will happen to the technically defaulted Treasurys?
How Will Defaulted Treasurys Trade?
The Treasury Market Practices Group (TMPG) made recommendations to the Fed back in December* on how technically defaulted Treasurys should trade and settle in the market. The biggest issue is to avoid having a maturing Treasury become “frozen” in the Fedwire settlement system. Unless something is done with that Treasury by 7:00 pm the day before maturity, it will become “frozen” and non-transferable the next day.
The TMPG recommended that all Treasurys which are unable to be matured (not enough money in the Treasury’s coffers) have their maturity date extended one day forward. In other words, keep rolling the maturity dates forward each day until they’re able to be paid off. Say the Treasury was unable to mature the March 6 T-Bill, then the bill’s maturity date would be changed to March 7, then March 10, then March 11 and so on and so forth until it’s paid off. This solution is operational within the Fedwire system and within bank’s trade processing systems. In the marketplace, there’s still a CUSIP, so the securities can be traded and transferred.
Coupons are a slightly different matter. There’s a choice to be made here. The coupon payments could be held for the holder on the coupon payment date or they could be attached to the defaulted Treasurys and transferred with them. The TMPG recommended that the coupons remain payable to the original holder of the securities on the coupon payment date. This decision opens the door for large money wire fails from the Treasury for a period of time. There is a risk factor here.
Also, it’s important to remember, there’s no compensation for investors who are holding technically defaulted Treasurys. Any back interest would require and act of Congress for reimbursement, so technically defaulted Treasurys would not accrue coupon interest each day and they would trade at their “clean” price.
As long as there’s a mechanism to settle technically defaulted Treasurys and trade them, the next question is the price? To put in mildly, a defaulted security carries a lot of uncertainty. There’s also a limited number of buyers; some investors would not be allowed to own them under any circumstances. I would price a technically defaulted Treasury like a term Repo plus an uncertainty premium plus an illiquidity premium [Price = Par – (carry + maturity uncertainty + illiquidity premium)]. The yield should start with the cost of the Repo financing until they’re paid off. We would know the term Repo rates and can guess how long it takes to pass a new debt ceiling. Say the term Repo rate is .15% for one week and .15% for two weeks and the debt deal is expected within a week, but it might take longer. In that case, I’d price the defaulted Treasurys to include that additional week of carry. Then, the illiquidity factor is a wildcard. You must add some yield to cover this, but I can’t guess what it’s worth.
Keep in mind, there will always be a rate where some traders and investors will own technically defaulted Treasurys in their portfolios and hold them until they’re paid off. There will certainly be an initial sell-off, but the market will eventually come back and have reasonable pricing. Remember, the whole Treasury market will not shut down. It’s silly to think it would.
U.S. Treasurys are used as collateral for margin, they’re the benchmark interest rate, and they have an extremely important role in the global financial markets. A technical default will affect their status, so don’t get me wrong. A Fed spokesman announced that the Fed would continue accepting technically defaulted Treasurys as collateral in Fed operations. A big question remains, however, can technically defaulted Treasurys be used as Repo collateral? That answer will have a major impact on their pricing. Also, is a technical U.S. Treasury default a credit event for Credit Default Swaps (CDS)? I can’t answer that one.
* “Operational Plans for Various Contingencies for Treasury Debt Payments”; Treasury Market Practices Group; December 2013.