Yesterday we described the various scenarios available to Treasury in the next few weeks should the shutdown and debt ceiling debacle carries on longer than the equity markets believe possible. As BofAML notes, however, the most plausible option for the Treasury could be implementing a delayed payment regime.
In such a scenario, the Treasury would wait until it has enough cash to pay off an entire day’s obligations and then make those payments on a day-to-day basis. Given the lack of a precedent, it is hard to quantify the impact on the financial markets in the event that the Treasury was to miss a payment on a UST; but the following looks at the impact on a market by market basis.
Impact of going past the X date
Given the lack of a precedent, it is hard to quantify the impact on the financial markets in the event that the Treasury was to miss payment on a UST. In 1979, the Treasury did delay payments on $122mn worth of bills maturing on April 26, May 3 and May 10, 1979. However, the Treasury blamed the delay on an unprecedented volume of participation by small investors and the unanticipated failure of word-processing equipment used to prepare schedules needed to cut them individual paper checks. The problem was cleared up within three weeks, and investors holding T-bills maturing on May 17, 1979, were paid on time. The late bill payments were also made, with interest.
In contrast, any debt ceiling breach today will be seen as a willful default by Congress on the country’s debt obligations and will have greater consequences. The economic effects will be felt via declining consumer and business confidence, reduced availability of credit and higher private borrowing costs.
The technical aspect of a treasury default
Treasury auctions: If the debt ceiling is not raised by October 17, we expect the Treasury to postpone the announcement of the 30-Year TIPS auction (scheduled for 11 am on October 17) and the 2s,5s, 7s announcement (scheduled for 11 am on October 24). With respect to the auctions, the debt ceiling allows the Treasury to issue new debt to replace maturing debt, as this does not add to the total debt outstanding. The problem would be an increase in net issuance, which ordinarily helps fund the deficit. In this scenario, our best estimate is that the Treasury would suspend coupon auctions and issue cash management bills (CMBs) totaling the size of the maturing debt. There is no guarantee, however, that the proceeds of the auction would be used to pay off the maturing debt – technically, they can be used to pay off obligations of a previous day under the delayed payment regime.
Bill rollover: Although Treasury can rollover maturities, bills are a little more complicated because they are issued at a discount to par. When Treasury issues new bills at a positive yield, the proceeds of the auction would be slightly less than what the Treasury will need to pay down the maturing bills. Once Treasury runs out of cash, the issue of prioritization would become relevant because it will need to scrape up some extra cash to make up for the discount factor on the new bills.
Repo market eligibility: In our view, Treasuries for which a coupon payment has been missed will continue to be eligible for repo market transactions. However, cash lenders in tri-party may ask to not be delivered the specific defaulted CUSIPs. Securities that are past their maturity date without the principal being paid cease to exist as securities. Instead, they will be considered IOUs between the Treasury and the holder. Such IOUs cannot be used in the securities market unless such a market develops separately for trading these issues.
If the Treasury were able to provide advance guidance that a principal payment will not be met, the security’s maturity date could be modified in advance in order to help systems maintain their classification as security (instead of an IOU). Treasury repo rates would likely rise as liquidity in the repo market deteriorates. In late July 2011, Treasury GC rates rose by nearly 30bp and MBS repo increased by 35bp as the X” date approached, though this was exacerbated by heavy money fund outflows.
Repo haircuts and exchange collateral: During the debt ceiling standoff in 2011 there was some concern that repo haircuts on Treasuries could increase in the event of a US government default or ratings downgrade. A ratings downgrade alone would not be sufficient to cause an increase in haircuts since haircut levels are not linked to ratings. Rather, cash lenders seek to maintain haircuts large enough to protect themselves from an adverse market move over the time period required to liquidate the collateral in the event of a counterparty default. Significant deterioration in market liquidity would be a more serious threat to existing repo haircut conventions than a rating downgrade. Going past the X date has the potential to trigger an increase in haircuts if liquidity were to deteriorate sufficiently.
Money fund holdings: SEC Rule 2a-7 does not require that fund managers liquidate their Treasury, agency, or repo holdings in the event of a US government downgrade or default, though there is some ambiguity about how defaulted securities would be treated. In our view, the bigger risk could come from investor outflows, though we expect MMF cash to be “stickier” than in 2011.
Fed purchases: In our view, the Fed can continue to buy Treasury securities even if payment were to be missed. The Federal Reserve Act does not explicitly have any qualifications around default and permits the Fed to buy any direct obligation of the United States. In 2008-2009, the Fed purchased agency debt as a part of QE1 well after the CDS on Fannie Mae and Freddie Mac were triggered.
Rating agencies: In the case of a missed payment, we believe that S&P would move the sovereign rating to Selective Default (SD). If multiple payments were to be missed, Fitch would also move the rating to Restrictive Default (RD)”. In our view, there is no concept of default by a specific CUSIP or cross-default for USTs. Further, there is no prospectus document with a Treasury offering defining default and the rating agencies would move the sovereign rating (not issue specific rating) to SD/RD. In all cases, even after the default is cured, we think all three rating agencies are likely to downgrade their current ratings by a notch.
Index eligibility: The eligibility of Treasuries with respect to any of the BofA Merrill Lynch US Fixed income indices will be unaffected, irrespective of rating changes. Sovereigns are exempt from rating criteria in single currency indices (Except Euro Broad Market). In the case of global indices, Treasuries are unlikely to fall out unless the average of the 3 ratings goes below investment grade.
CDS: We believe the contract would be triggered after a three-day grace period (since no grace period is defined, ISDA default is likely three days). It is important to remember that US CDS contracts are rather illiquid despite the recent spike in volumes and spreads (Chart 4). There is less than $5bn in outstanding notional and will likely be traded by only non-US counterparties (payout in euros).