With just days before Oct. 17, when the Treasury Department projects it will run out of money to pay bills, skittish markets are starting to fear the previously unthinkable: What if the United States government missed a payment on its debt
A default would roil financial markets worldwide, with the economic impact far more damaging than the ongoing partial government shutdown. But since American debt has long been the world's safe-haven investment, industry professionals have no idea what exactly would happen or how to prepare.
"We are entering uncharted territory in financial markets," said Josh Galper, managing principal of advisory firm Finadium. "We are are already in strange and unusual times.
The Treasury must pay debt service on Oct. 17, Oct. 24 and Oct. 31, said Robert Toomey, associate general counsel at the Securities Industry and Financial Markets Association.
Moody's Not Gloomy
Some say the Treasury could prioritize payments to avoid default.
"We believe the government would continue to pay interest and principal on its debt even in the event that the debt limit is not raised, leaving its creditworthiness intact," Moody's said in an Oct. 7 memo.
But others aren't sure if the government has the ability — or authority — to do that. Treasury Secretary Jack Lew may shed some light before the Senate Finance Committee on Thursday.
SIFMA believes unpaid Treasury bills could possibly "disappear" from the system, because they could not be sold or otherwise financed. That's key because Treasuries are much more than individual debts owed to bondholders. They are the financing foundation for other markets, including much of the $4 trillion repurchase, or repo market, which provides short-term liquidity. Reports emerged Wednesday that repo dealers aren't accepting Oct. 17-31 bills as collateral.
"Repo can be seen as staid and boring but in many cases it is the grease of financial markets," Galper said. When repo markets seized up after Lehman Bros. failed in 2008, it caused a liquidity freeze that rippled through the financial system.
The 2008 financial crisis may not be the best model for a debt ceiling breach. The U.S. government is far more massive than Lehman, but analysts say markets know it has the ability, if not the leadership, to make good on its debts. Any default would be short-term, they say, and would be "cured" almost immediately.
Standard & Poor's, which in 2011 became the only ratings agency to lower the U.S. credit rating below AAA, said last week that if the debt ceiling were breached, it would assign a "Selective Default" rating. That would be temporary, but S&P or rivals could issue permanent downgrades.
A TARP Moment?
"It is possible we could have a TARP-like" moment, said Ellen Zentner, senior economist at Morgan Stanley. In 2008, when the Congress initially balked at the Bush administration's plan to shore up the financial system, the Dow plunged 778 points. If something similar happened now, it could quickly force Congress to raise the debt limit, she said.
Zentner said she was also concerned about the possible impact of a default on money markets, which invest in Treasury bills, commercial paper and repos. When they froze up after Lehman, companies' ability to meet payroll and other day-to-day expenses was threatened.
Short-term markets are already pricing in the "unthinkable," she said. One-month T-bills auctioned Tuesday spiked to 0.35%, higher than in 2008, or the 2011 debt ceiling standoff. While money market funds are not "panic selling" yet, Zentner said, they are shifting from U.S. debt.
The Federal Reserve still has tools to inject liquidity into frozen markets, but a default could plunge the U.S. and much of the world back into recession.
A default would likely drive up borrowing costs permanently, on everything from mortgages to business loans.
Despite Washington shenanigans, the U.S. benefits from being the best bet for investors in a still-shaky global economy.
"There are no great alternatives there right now," said Ernie Patrikis, a White & Case partner who was formerly general counsel to the New York Fed and an FOMC alternate. But "it's not going to be that way forever."