The chain reaction from a potential default suggests a slow spread of damage through various parts of the banking system, particularly the US$5 trillion repurchase agreement market, which many companies rely on for funds.
The Treasury Market Practices Group, a group of market participants, has been looking into operational challenges of a US default since the 2011 fight. It noted that other major events such as a terrorist attack, a failure of trading or other operational systems, or a natural disaster could also delay a debt payment.
One potential problem is that the New York Fed’s Fedwire Securities Service, which is used to hold, transfer and settle Treasuries, would need some manual daily adjustments, as it otherwise cannot transfer bonds that are past their maturity date, the group said in meeting minutes from last year. Other systems may have similar problems, it said.
Treasuries are widely used to back loans in the repo, or repurchase agreement, market, and in privately traded derivatives and for a host of securities traded on exchanges. Ownership and possession of the bonds is transferred regularly as part of this collateralization process.
However, put sand in the gears of the transfers, and anarchy may ensue.
After the September 2001 attacks on the World Trade Center and the Pentagon, market participants struggled to identify who their counterparties were in the repo market, and even had difficulty grasping whether their net Treasuries position was a long or short one, after trading records were destroyed.
The number of trade “fails,” when the borrower does not supply Treasuries to settle a loan, surged in the weeks after the attacks, initially rising because of operational problems and then staying high as the cost of obtaining Treasuries to settle a loan was as expensive as the cost of allowing a fail.
To resolve the issue, the Treasury held a special auction of 10-year notes to increase supply and help settle the loans.
The US has defaulted once before, in 1979, when lawmakers were blamed in part for allowing negotiations to go down to the wire before raising the debt ceiling.
After that, back-office errors at the Treasury, caused the government to be late in redeeming three series of Treasuries bills, according to an academic paper by Terry Zivney and Richard Marcus published in the Financial Review in 1989. The failure caused rates to rise, and the government faced lawsuits from investors hurt by the delays in repaying the bonds, they said.
Markets now are far more complicated. Battles over ownership, interest paid or owed and a host of other issues relating to the transfer of the securities would likely be mired in legal disputes. US debt is also considerably higher, and there is greater foreign ownership of Treasuries. The economy is also more vulnerable, making the risk of a creditor exodus a far more damaging prospect for the country.
“The minute we default, there would be a complete collapse in the bond market,” said Peter Schiff, chief executive officer of Euro Pacific Capital and a critic of US government spending habits.
That would leave the US struggling to refinance more than US$4.6 trillion that come due within two years, including US$3 trillion of Treasuries due to mature this year.