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Catastrophic Consequences of a U.S. Default Explained

Breakout
Catastrophic Consequences of a U.S. Default Explained

As we close out the first week of the government shutdown, a bigger and even more toxic disaster is creeping into the fray that could make the contentious budget battle look like a slap fight. The Treasury Department said Uncle Sam will be broke by October 17th unless something is done. Treasury secretary Jack Lew hammered home that point Thursday by releasing an unusually ominous statement that warned of catastrophic risks to the economy.

House Speaker John Boehner has said he won't let the government default on its debt, but until steps are taken to raise the nation's debt ceiling, the possibility of default is still theoretically alive.

"If they seriously default on the debt, what we're really talking about is a depression," says veteran financial sector analyst Richard Bove, VP of research at Rafferty Capital Markets. In the attached video he explains how the fallout would be a lot worse than the recession suffered in 2008 and the aftershocks would be felt for at least a decade.

"The first thing you have to do is look at who holds the debt," Bove says of the $16.7 trillion of bonds the U.S. currently has outstanding. "The first, biggest owner (of U.S. debt) is the social security fund, so you'd have all of these people who are receiving social security payments who now have to question whether they'll get their payments."

Clearly, that would cause a huge disruption to millions of Americans. But Bove says that is only the beginning since the second biggest holder of Treasuries (at about 12% of the total) is the Federal Reserve, which has "91% of its assets backed by U.S. government debt."

If the value of those assets were to decline, which they indisputably would in a default, Bove says the net effect would be that "we have nothing of value backing the dollar."

They're actually "Federal Reserve Notes" as well as the number one asset of choice held in the reserves of governments and businesses all over the world. A plunge in Treasuries would also devalue the dollar, which would instantly make everything we buy more expensive, and in turn destabilize countries and economies all over the world.

"Eleven-percent of all U.S. debt is owned by the Chinese," he says. "That $1.4 trillion represents about a third of the reserves of the People's Bank of China, so what we've now said to the PBOC is, 'Watch out, we may hit the value of a third of your assets and you can't do anything about it.'"

And this isn't even half of it.

As Bove explains, money market funds, which are used by virtually every person with a savings or investment account, are also "heavily loaded with Treasuries." So are most bond funds and so-called balanced funds (growth and income funds). A default on U.S. debt would not only cause money funds to "break the buck" --not be able to pay 100-cents for each dollar invested)-- but would also cause forced selling by countless other funds that are mandated to immediately sell any asset that has defaulted.

"That could easily put $750 billion of Treasuries on to the market," Bove says, inferring that rates interest rates would also spike, and normal borrowing/lending transactions would end.

Speaking of banks, the U.S. banking industry holds over a trillion dollars worth of Treasuries and another trillion dollars of government issued mortgage-backed securities, Bove says. If those bonds were to go down in value, he says the banks would also have to "write down the value of those assets and, in essence, wipe out their equity." It would make the banks insolvent.

To summarize, Bove asserts that a default is unthinkable because it would trigger a huge reduction in the value of U.S. debt, which would go beyond disrupting social security payments. A default would upend money markets, destroy bond funds, slam the brakes on lending, cause interest rates to spiral, make our banks insolvent, and deal a blow to our foreign trading partners and creditors around the globe; all of which would throw the U.S. and the world into economic disarray.

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