Debt Ceiling Crisis: How a Default Could Happen

The United States is inching closer to calamity, as lawmakers continue to argue over what it will take to raise the country’s debt ceiling by $31.4 trillion.

This has raised questions about what will happen if the United States does not raise its borrowing limit in time to avoid defaulting on its debt, as well as how the major players are preparing for this scenario and what would really happen if the Treasury Department didn’t repay its lenders.

Such a situation would be unprecedented, so it’s hard to say for sure how it would play out. But this isn’t the first time investors and policymakers have had to ask “what if?” and they’ve been busy updating their playbooks to find out how they think things may play out this time around.

As negotiators appear to be heading for a deal, time is running out and there is no certainty the debt ceiling will be lifted until June 1, the earliest the Treasury estimates the government will run out of cash to pay. all his bills on time. , known as the “X date”.

Big questions remain, including what could happen in the markets, how the government anticipates default and what will happen if the US runs out of cash. Here’s a look at how things could play out.

Before date X

Financial markets have grown more jittery as the United States moves closer to the X date. This week, Fitch Ratings announced it was placing the country’s top AAA credit rating for possible downgrade. DBRS Morningstar, another ratings firm, did the same on Thursday.

For now, the Treasury is still selling debt and making payments to its lenders.

This has helped ease some concerns that the Treasury will not be able to repay maturing debt in full, as opposed to just paying interest. This is because the government has a regular schedule of new Treasury auctions where it sells bonds to raise fresh money. The auctions are programmed so that the Treasury receives its new borrowed cash at the same time as it pays off its old debts.

This allows the Treasury to avoid adding a lot to its $31.4 trillion debt stock – something it cannot do at the moment since it took extraordinary measures after reaching a hair’s breadth of the debt limit on January 19. And that should give the Treasury the liquidity it needs to avoid any disruption in payments, at least for now.

This week, for example, the government sold two-year, five-year and seven-year bonds. However, that debt doesn’t “settle” – meaning the money goes to the Treasury and the securities go to buyers at the auction – until May 31, coinciding with three other maturing securities. .

Specifically, the new money borrowed is slightly greater than the amount to come. The Treasury borrowed $120 billion this week on the three different notes. While about $150 billion in debt comes due on May 31, about $60 billion is held by the government from past crisis interventions in the market, meaning it somehow ends up pay off that part of the debt itself, leaving another $30 billion. in cash, according to analysts at TD Securities.

Part of that could go to the $12 billion in interest payments the Treasury also has to pay that day. But as time passes and the debt limit becomes harder to avoid, the Treasury may have to postpone any additional fundraising, as it did during the debt limit impasse. in 2015.

After date X, before default

The US Treasury pays its debts through a federal payment system called Fedwire. Major banks hold accounts with Fedwire, and the Treasury credits these accounts with payments on its debt. These banks then pass the payments through the plumbing of the market and through clearinghouses, like the Fixed Income Clearing Corporation, with the cash eventually landing in the holders’ accounts of domestic pensioners to foreign central banks.

The Treasury could try to postpone default by extending the maturity of maturing debt. Due to Fedwire’s setup, in the unlikely event that Treasury chooses to push back its debt maturity, it will have to do so by 10 p.m. the day before the debt is due, according to plans. emergency established by the professional group Securities Industry and Financial Markets Association, or SIFMA. The group expects that if this is done, the maturity will only be extended by one day at a time.

Investors are more worried that if the government exhausts its available cash, it could miss an interest payment on its other debts. The first big test will come on June 15, when interest payments on notes and bonds with an original maturity of more than a year come due.

Moody’s, the rating agency, said it was very concerned about June 15, a possible day when the government could default. However, it could be helped by corporate taxes pouring into its coffers next month.

The Treasury can’t delay a non-default interest payment, according to SIFMA, but it could notify Fedwire by 7:30 a.m. that the payment won’t be ready for the morning. He would then have until 4:30 p.m. to make the payment and avoid default.

If a default is in concern, SIFMA – alongside representatives from Fedwire, banks and other industry players – has planned to call up to two calls the day before a default and three more calls the day a payment is due, with each call following a similar script to update, assess and plan for what might unfold.

“In terms of settlement, infrastructure and plumbing, I think we have a good idea of ​​what could happen,” said Rob Toomey, head of capital markets at SIFMA. “It’s the best we can do. As for the long-term consequences, we don’t know. What we’re trying to do is minimize disruption in what will be a disruptive situation.

Default and beyond

A big question is how the United States will determine if it has indeed defaulted on its debt.

The Treasury could default in two main ways: missing an interest payment on its debt or failing to repay its borrowings when the full amount becomes due.

This sparked speculation that the Treasury Department might prioritize payments to bondholders ahead of other bills. If bondholders are paid but others are not, rating agencies will likely decide that the United States has dodged default.

But Treasury Secretary Janet L. Yellen suggested that any missed payments would essentially amount to a default.

Shai Akabas, director of economic policy at the Bipartisan Policy Center, said a harbinger of impending default could come in the form of a failed Treasury auction. The Treasury Department will also closely track its spending and incoming tax revenue to predict when a missed payment might occur.

At this point, Mr. Akabas said, Ms. Yellen is likely to issue a warning with the exact moment she predicts the United States will not be able to make all of its payments on time and announce the plans. emergency that it intends to pursue. .

For investors, they will also receive updates through industry groups following key deadlines for the Treasury to notify Fedwire that it will not make an expected payment.

A fault would then trigger a cascade of potential problems.

Ratings firms said a missed payment would merit a US debt downgrade – and Moody’s said it would not restore its Aaa rating until the debt ceiling was no longer subject to the tightrope policy .

International leaders have questioned whether the world should continue to tolerate repeated debt ceiling crises given the critical role the United States plays in the global economy. Central bankers, politicians and economists have warned that a default would most likely tip America into a recession, leading to waves of second-order effects ranging from business bankruptcies to rising unemployment.

But these are just a few of the known risks to hide.

“This is all in uncharted waters,” Mr. Akabas said. “There is no playbook to follow.”