Some of Wall Street’s biggest banks are preparing to curtail use of U.S. Treasurys in August as a precaution against any turbulence that could follow if warring lawmakers fail to raise the U.S. debt ceiling soon, a senior bank chief said.
One strategy, which bank executives only agreed to discuss without attribution due to the political sensitivities related to discussing Treasury debt, is to have more cash on hand to put up as collateral against derivatives and other transactions, decreasing the financial system’s reliance on Treasurys.
"We’re planning to lower our reliance on the use of Treasurys in early August and have more cash on hand as a contingency measure," said a U.S. bank chief.
Investors worldwide own large amounts of the $9.7 trillion of debt that has been sold by the U.S. government as part of their portfolios. But nearly 40 per cent of the existing U.S. Treasury debt — about $4 trillion — is used to back deals in the repurchase, futures and swaps markets, say JPMorgan Chase estimates.
It is this key role that Treasurys play as collateral for the wider financial system where turmoil could follow any missed payment resulting from the debt ceiling fight. The top quality and liquidity of Treasury debt means it can be used to back transactions relatively cheaply, with banks or clearing houses only requiring a small "haircut" or discount on the value of the debt to reflect credit risks.
The Treasury Department has said that in the absence of a deal to increase the U.S.'s legal borrowing limit of $14.3 trillion the U.S. could default on its debt by August 2. Wall Street has told the Treasury that such a scenario could create huge problems for financial markets.
In a letter to Treasury Secretary Tim Geithner, Matthew Zames, a JPMorgan Chase executive and chairman of the Treasury Borrowing Advisory Committee, wrote in April that "a default could trigger a wave of margin calls and widening of haircuts on collateral, which in turn could lead to deleveraging and a sharp drop in lending."
The Treasury Market Practices Group, which is sponsored by the Federal Reserve Bank of New York and includes the biggest repurchase market dealers, Bank of New York Mellon and JPMorgan Chase, declined to comment.
U.S. Treasury yields currently indicate no stress, and yields have fallen to new lows as economic growth has declined. However, the market is being closely watched.
“We will continue to monitor the liquidity environment and appropriate collateral haircuts as the US approaches the debt ceiling,” said a spokesperson for the CME Group, which accepts U.S. Treasurys against futures positions.