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How a debt ceiling nightmare scenario could unfold

Sam Ro
Managing Editor

In the next several weeks, Congress has to raise the US debt ceiling, which is the limit on the amount of debt the Treasury can issue, or risk going into technical default. In this grim scenario, the Treasury would begin missing payments on outstanding financial obligations.

Treasury Secretary Steven Mnuchin has said the absolute last day to raise the debt ceiling is September 29, after which the US would be in default.

“A quantitative assessment of the overall impact on the economy is elusive,” said JPMorgan’s Michael Feroli who attempted to forecast what could happen in what he labeled the “extreme scenario.”

“[T]here is no historical parallel to assess how a failure to raise the debt ceiling before the ‘drop dead’ date would affect the economy,” he wrote. “Of course, economic history is littered with sovereign defaults, with hugely damaging results. However, those examples are invariably of countries that made the decision that continuing to meet their obligations was unbearably costly, not cases where the ability to pay was not in question but was held up by political maneuvering.”

The U.S. Capitol is reflected in water as two Ducks swim past, October 15, 2013 in Washington, DC. (Mark Wilson/Getty Images)

Feroli is among the consensus that believes there’s almost no chance Congress would allow such a catastrophe to occur. Nevertheless, he and his team offered their thoughts on what could possibly happen.

Five ways a default would hit the economy

Feroli reiterates that it is “impossible” to quantify the impact of a default. But he identified five ways it could hit the economy and financial markets.

  1. “Fiscal contraction”: The government would no longer able to run a budget deficit. Feroli estimates that Federal revenues cover 60-70% of spending. In this scenario, Social Security recipients could see their checks shrink.
  2. “Increased uncertainty”: A default certainly wouldn’t help how people see the US government. Uncertainty would spike and confidence would crash as businesses and consumers lose faith in the government, which Feroli characterized as “the largest single agent in the US economy.”
  3. “Sovereign ratings”: S&P, Moody’s and Fitch would likely downgrade their ratings on the US. S&P already stripped the US of its pristine AAA rating during the 2011 debt ceiling crisis.
  4. “Treasury demand”: Foreign entities own about 45% of outstanding Treasury securities, Feroli noted. A default would hurt that demand, and less demand means higher yields. “[Our] work has found that each additional 25bp of interest expense would add $260 billion to the budget deficit over a 10-year period.”
  5. “Financing markets”: US bond market liquidity is juiced by Treasuries through the repo market. Here’s Feroli: “Currently, repo secured by US Treasury collateral amounts to $1.6 trillion and comprises almost 75% of the total repo market. A sharp repricing of Treasury collateral in response to a technical default would likely increase haircuts, potentially leading to significant margin calls, some forced deleveraging, and a decline in lending capacity in financial markets.”

“What is notable is that many of the effects impact financial markets and institutions rather than directly affect the real economy,” Feroli noted. “However, as the Lehman Brothers experience of 2008 vividly reminds us, shocks originating in the financial sector can leave deep and long-lasting scars in the real economy.”

In other words, Feroli is saying that there are no models that will sufficiently capture what could possibly happen. That’s scary. It’s worth noting at this point that the economic crisis that followed the Lehman Brothers bankruptcy had some folks questioning the viability of capitalism.

Why a default would be “cured quickly”

The market reaction would be swift and violent in the extreme scenario. Feroli thinks the market response would be so substantial that policymakers would have no choice but to act fast.

“In the hypothetical scenario of a technical default, it would presumably be cured quickly,” he said. “This presumption is partly a function of the signal that financial markets likely would send to the political class. After all, the 2011 debt ceiling crisis did not entail a full-blown technical default, and even that caused stocks to sell off almost 20%.”

Indeed, it is this political class that can raise the debt ceiling and prevent a default from happening.

“Given the centrality of Treasury securities in the financial system, even a quickly-cured default could be a major shock to that system which would reverberate in the real economy,” he said.

“Because of the enormity of the potential costs, we expect Washington will raise the debt ceiling in a timely manner.”

Sam Ro is managing editor at Yahoo Finance.

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