Mon, Jan 21, 2013 - Page 9 News List

Could markets handle a US default?

Although the likelihood of a US default is considered slim by most analysts, the consequences could be catastrophic as financial systems and markets are simply not equipped to handle such an occurrence

By Karen Brettell  /  Reuters, NEW YORK

Illustration: Yusha

Squabbling in Washington over the debt ceiling is again raising the specter that the US may be forced to delay payments on its debt. While the stigma of a default would be damaging enough to investor sentiment, the chaos from a breakdown in financial markets’ systems that might result would be even scarier.

A failure to make payments on US Treasuries, however brief, would create widespread damage in short-term funding markets, which are crucial to daily operations of financial institutions, investment firms and many corporations, analysts and investors say.

In the event of a default, confusion would be rampant as trading systems struggle to identify, transfer and settle bonds that have matured, but have not been repaid. Interest rates would surge and investors would likely sell stocks and commodities as they fled risky assets, analysts say.

However, that does not mean investors would necessarily run to the safety of Treasuries. Many US government bonds could be shunned as investors worry about which issues are in default — even longer-dated issues that could have a coupon payment due that would potentially be in jeopardy.

A default could also trigger a wider paralysis in the financial system that could quite quickly stall the economy, as happened at the height of the financial crisis in September 2008.

For starters, money market funds are not allowed to hold defaulted collateral. These funds pulled back on making loans in 2011, when the ceiling was last an issue, and some analysts fear this time could be worse, potentially creating broad funding problems and sending the cost of borrowing in short-term markets — including those in repurchase agreements or loans based on the London Interbank Offered Rate, or Libor — surging.

The US Treasury hit its US$16.4 trillion debt ceiling — the legal amount it is allowed to borrow — on New Year’s Eve. The US Department of the Treasury will run short of funds as early as the middle of next month, so legislation is needed to increase the borrowing limit. This had been a formality for years but turned into a political standoff between congressional Republicans and the White House over government spending levels in the summer of 2011. The resulting battle roiled markets concerned about US political gridlock and its impact on the economy.

The likelihood of a default on US Treasuries has in the past been seen as so low that many parts of the market fail to even account for it in planning and paperwork. For example, unlike other debt, such as corporate bonds, Treasuries documentation has no grace period to make up for missed interest or principal payments.

Many banks and investors may not even have the systems needed to screen out which Treasuries have principal or interest payments due that are most at risk of not being paid.

“No one is going to build a system to assume you have a defaulted Treasury floating around there; it’s not a baseline assumption,” said Michael Cloherty, head of US interest rate strategy at RBC Capital Markets in New York.

Treasury bills maturing at the end of next month and in March are most vulnerable to default, though analysts say hundreds of other issues also have coupon payments due at the end of next month. Rates on some short-term debt maturing in that time have risen and now yield more than similar debt maturing in April, a sign that a dislocation has started.

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