No one expects it to happen, but everyone’s making sure they’re prepared for it.
Banks, funds and asset management firms holding U.S. government bonds are drawing up contingency plans on how to deal with potentially the most cataclysmic financial and economic event of all—a default by the United States.
The overwhelming consensus among all the firms contacted by Reuters is that Republicans and Democrats will come together at the 11th hour and avert disaster.
But the closer Washington’s budget funding impasse gets to preventing the country’s $16.7 trillion debt ceiling from being raised later this month, the more worried they are becoming.
A default by what has long been viewed as the world’s safest credit would be such a seismic event that there appears to be no accepted playbook for its eventuality, despite the trillions of dollars of investments that would be affected.
“You can literally tear up every textbook you’ve ever read on finance. You could quite literally reverse that entire world view in the space of a day,” said Ramin Nakisa, global asset allocation strategist at UBS.
“We are going to have to completely rethink the way we assess risk if U.S. Treasuries suddenly become a risky asset.”
Fund managers will first have to communicate a strategy or contingency plan to their clients.
Since the 2008 collapse of Lehman Brothers, senior asset management officials are known to meet regularly and consult closely with institutional clients such as pension funds over how to protect their portfolios in times of market stress.
The U.S. credit rating downgrade in August 2011, for example, forced many portfolios to redraw guidelines on how to manage non-AAA-rated securities.
“In speaking with advisers, we advocate investors should stay the course. Trying to time markets is not something we advise,” said Andrew Goldberg, global market strategist at JP Morgan Asset Management, which has $1.5 trillion of assets under management and operates in more than 40 countries around the world.
Very few of the 15 banks and funds contacted by Reuters were willing to speak on or even off the record about their plans, citing the sensitive nature of the issues.
Standard Life Investments, one of Britain’s biggest insurance funds with $287 billion of assets under management, is taking no chances even though it believes a U.S. default is “very unlikely.”
“The Global Investment Group of senior managers has discussed the potential outcomes in detail,” said Andrew Milligan, Standard Life’s head of global strategy, declining to give specific information on the plans being drawn up.
It’s a Totally Different Game
Because the dollar is the world’s reserve currency, and U.S. sovereign debt is the benchmark against which borrowing costs across the globe are measured, any failure by the United States to pay its debts would be unprecedented in its potential impact.
The U.S. Treasury itself warned last week that a default would be potentially “catastrophic” and would “reverberate around the world.”
A previous political standoff over raising the debt ceiling which took the country to the brink of default in August 2011 prompted credit rating agency Standard & Poor’s to strip the United States of the AAA grade it had assigned since 1941.
Treasury bonds and bills remain the most liquid government securities in the world, however, and form the lion’s share of the $11 trillion of central banks’ foreign exchange reserves.
No country rated AAA or AA, the highest investment-grade categories, has ever defaulted.
But the collapse five years ago of Wall Street giant Lehman Brothers, which triggered the global financial crisis and the worldwide “Great Recession,” was also something most observers said would never happen.
And just two years ago, a breakup of the eurozone seemed possible, with many predicting Greece’s mountainous debt burden would force it out of the 17-nation club. Citigroup’s chief economist Willem Buiter last year famously attached a 90 percent probability to “Grexit” coming to pass within 18 months.
The likelihood of a U.S. default is far lower—a Sept. 30 poll of economists by Reuters put it at less than 10 percent. But even that is not an insignificant risk.
“We have started to look at collateral in the past few days—client collateral posted to us, and also at collateral we post out,” said a risk officer at one of Wall Street’s biggest banks.
“No senior executive has sent out a memo asking for X, Y or Z and a report on their desk the next morning, although that might happen this Friday if there’s still no resolution.”
The United States will have until the end of the month to pay its bills, but beyond that default looms.
S&P has said the country will be downgraded to “selective default” if it fails to service a debt obligation, which could trigger widespread selling of U.S. bonds by funds whose rules only allow them to hold investment-grade debt. Fitch Ratings has meanwhile warned that failing to raise the debt limit would put the full faith and credit of the United States into question.
The United States’ biggest creditors are getting twitchy. China said on Monday it is “naturally concerned” and that Beijing and Washington have been in touch over the issue.
Japan’s finance minister also pressed the United States on Tuesday to quickly resolve the deadlock while the International Monetary Fund’s chief economist said a U.S. default could lead to a recession “or even worse.”
Money market funds are among the largest holders of Treasury notes and bills, with around $2.5 trillion of assets under management. They can hedge against risk, like other market participants. But dumping these assets all at once isn’t an option because trading in them is their raison d’etre.
“They’re definitely talking to their risk people. But strategy? It’s impossible to say—they will be playing their cards very close to their vests,” said Larry McDonald, head of global strategy at futures brokerage Newedge in New York.
He said that “99.99 percent of the time these guys are dealing with interest rate risk, not credit risk. It’s like taking a guy from the NBA and putting him on the ice at Madison Square Garden. It’s a totally different game.”