What are options on debt default? Bad and worse

10/08/2013 4:06 PM

10/15/2013 5:31 AM

The federal government won’t automatically or immediately default next week if it hits the legal limit on debt without an agreement to raise it from Congress and the White House.

That’s not to say there won’t be consequences for failing to raise the so-called debt ceiling. Key voices in financial markets are warning Congress and the Obama administration the consequences could be dire. The stock market, which had been on a roll this year, has fallen steadily over the past two weeks on fears that Washington will do more economic harm.

But on the specific threat of the U.S. government defaulting on its obligations to bondholders, it wouldn’t necessarily occur immediately next week.

A lot depends on which of two paths the Obama administration takes should politicians lead the nation to the cliff’s edge. The administration could try to prioritize who gets paid first in the event that money runs dry, or it could decide to pay all creditors roughly 68 cents on the dollar as money comes in every day.

On or around Oct. 17, the government would have to pay its bills with whatever money is coming into government coffers on a daily basis. The Bipartisan Policy Center, a think tank with budget experts from both major political parties, thinks the U.S. government can count on about $10 billion to $15 billion a day of incoming tax revenue and other payments to the government to pay what’s owed to creditors, retirees and doctors in the Medicare system.

The most important payment, in terms of the creditworthiness of the U.S. government, is the interest on government bonds due to investors. And it’d be almost a month before a payment is due that’s so large that daily income revenues couldn’t cover what’s owed.

According to the center’s estimates, the next interest payment due after Oct. 17 is about $6 billion, due on Oct. 31.

That would be within the range of expected daily incoming revenue. It’s not until Nov. 15 that interest payments stretch significantly above the day’s projected incoming revenue, making it impossible to make the interest payments and cover daily debts such as payroll. On that day, the government owes interest payments of about $29 billion. Some Republicans say the government can avoid default easily by just paying the top-priority bills such as interest on bonds plus Social Security.

There’s a catch, however. It’s not clear the plethora of government computer systems could prioritize who gets paid and when.

“We don’t know if they have the technical capability to do that,” said Shai Akabas, a senior policy analyst for the Bipartisan Policy Center. “Computer systems are not set up for that, it is not the modus operandi.”

Instead of paying 100 percent of some bills and 0 percent of others, a Treasury Department inspector general’s report following the last debt-ceiling showdown concluded the government favored paying everyone across the board a reduced percentage based on how much it had coming in.

“You cannot pay some bills and not others and think somehow that the fact that you’re paying some bills protects you from a loss of credit worthiness,” Obama said Tuesday in a news conference.

After Oct. 17, incoming revenues to the federal government would cover about 68 percent of the bills. One option would be to slash spending by 32 percent, or more than $1 trillion. Economic researcher Ed Yardeni, in a Tuesday note to investors, said that while retirees would still be paid, such cuts would hit most of the services that government provides and “would leave us literally defenseless, and park-less.”

If the Treasury Department chose to pay bondholders at the expense of Social Security recipients and military pensioners, the rating agency Standard & Poors would not consider the U.S. government in default.

“Failure to pay or reduced payments on non-debt obligations, such as funds owed to government contractors or benefits recipients, would likely have negative economic impacts but would not be considered a default under our rating criteria,” John Piecuch, an S&P spokesman, told McClatchy.

That’s a point echoed by Rep. David Schweikert, R-Ariz.

“Doesn’t mean it’s happy and easy, but anyone that uses the word default is being horribly disingenuous, because that means we wouldn’t pay the interest obligations we have on our bonds, and we have massive amounts of cash to cover that obligation,” he said in an interview Tuesday with a Phoenix television station.

If the government missed any bond payments because it couldn’t or wouldn’t prioritize who gets paid, it’s a different story.

“Should the government fail to service a debt obligation, we would lower the sovereign rating to ‘SD’ (selective default),” said Piecuch. “This designation indicates that the issuer, in this case the U.S. government, has failed to service one or more of its outstanding debt obligations, which include U.S. Treasury bills, notes and bonds.”

And that’s a bad place to be, in the company of Zimbabwe, Greece and Argentina, countries that failed to pay bondholders and are now financial pariahs. The cost of future borrowing for the United States would likely jump, making it more costly to borrow to cover the debts the nation already owes, darkening the outlook for the nation’s already precarious longer-term finances.

There’s a catch here, too, however. The U.S. dollar is the world’s reserve currency, used as a reference in transactions everywhere. U.S. government debt is still considered a safe haven from risk. Markets could note that nations that default usually do so because they can’t pay their bills. The United States would be saying it won’t.

“There’s no immediate debt crisis. It’s a self-induced, manufactured, ‘we won’t pay the bills’ crisis,” said Bob Bixby, head of the budget watchdog group Concord Coalition. “Everyone understands the U.S. is certainly good for the money. It isn’t like we can’t pay our bills right now.”

In fact, thanks to the Federal Reserve’s controversial purchase of $85 billion a month in government and mortgage bonds, depressing the interest rate on government-issued bonds, the cost of borrowing for the U.S. government is unusually low.

So why worry?

One reason is that while the interest payments appear manageable initially, the government also would have to roll over on Oct. 24 about $57 billion in government bonds that are reaching maturity, and another $115 billion on Oct. 31.

The rollover of maturing debt allows investors to continue holding government bonds, and it’s not guaranteed there’d be sufficient numbers of interested parties until the debt-ceiling debate is resolved. The bond markets could seize up.

“It’s very difficult to project a world where we have started to prioritize . . . how Treasury operates in that period, how they do the auction, it’s just uncharted territory,” said Akabas of the Bipartisan Policy Center. “Assuming that everything will go as standard probably reflects an overconfidence of which we can’t be sure.”

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