Perdido 03

Perdido 03

Monday, September 30, 2013

Government Shutdown Isn't The Problem, The Debt Ceiling Fight Is

From the NY Times:

Most Wall Street economists have said that the consequences of a temporary government shutdown would be relatively insignificant, particularly because spending on essential services — a large portion of the budget — would continue. Citigroup economists estimated on Friday that a one-week shutdown would probably cause a 0.1 percent hit to the national economy.

In the long run, not a big deal, so long as some resolution is reached that allows for successful negotiations over raising the debt ceiling in a couple of weeks - or otherwise this:

The main focus on Wall Street is the possibility that the government will stop making payment on its outstanding bonds when the current borrowing limit is reached, which is expected to happen on Oct. 17.

Treasury bonds are viewed as the bedrock of financial markets, thanks largely to the assumption that the United States will always pay its debts. Most analysts say that if that were thrown into question, the consequences would be catastrophic, and largely unpredictable.

“Even if it’s a brief failure, it would forever be a signal to the market that you can’t trust the United States government to make its payment when it’s due,” said Millan Mulraine, the director of United States research and strategy at TD Securities. “That would shake the foundations of the global financial system.”

During a previous debt ceiling battle, back in 1979, Congress didn't get a deal done until the very last minute, causing an "accidental default" on $120 million of the nation's debt.

The Atlantic reported back in January that the Treasury paid every cent owed, plus interest, as a result of that default, but that still didn't stop short term interest rates from jumping 0.6%.

Here's what has changed since the 1979 "accidental default":

It would be much, much closer to Armageddon if we did this today. Blame shadow banking. The past few decades, there's been a shift in the financial system towards things that, economically-speaking, look like a bank, act like a bank, but technically aren't banks. Institutions like hedge funds, structured investment vehicles, and money-market funds all borrow short and lend long, just like a bank, but do so outside the web of regulations that control, and safeguard, regular, old banks. In other words, they trade FDIC insurance and access to the Fed window for complete financial freedom.

They are the shadow banking system, and they didn't really exist back in 1979. At least not anywhere near today's scale. And they, along with conventional banks that have gotten into the game, use Treasury bonds as a kind of money. They use Treasuries as collateral for cash in repurchase agreements (repos) to fund their daily trading, with those same Treasuries often getting "rehypothetecated" -- that is, reposted as collateral by whoever first got it as collateral -- in a dizzying chain of financial connections. It's almost impossible to predict what would happen to these collateral chains if there was any kind of default on Treasuries, but it would almost certainly be 1) bad, and 2) very bad. Think about it this way. Treasuries are supposed to be the safest of safe assets, and as such are the lifeblood of the financial system, which has been running low on safe assets since mortgage bonds turned out not to be so. Removing the system's blood is not something we want to try. The last time something like that happened was, of course, back in 2007-08 with subprime bonds, and it set off and old-fashioned bank run on the uninsured assets of the shadow banking system that nearly brought down the world economy.

About the best thing that could happen here is that the House Republicans force the shut down tonight, public opinion (and the financial markets) force them to rethink that shutdown strategy with the Dow plunging a few hundred points, and then they come back to the table and make a deal that allows for a reasonable outcome in the debt ceiling increase fight next month.

But the words "reasonable" and "House Republicans" don't really belong in the same sentence, do they?

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