Time to Think the Unthinkable on US Debt

President Obama and Speaker of the House Rep. John Boehner
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President Obama and Speaker of the House Rep. John Boehner

Raising the prospect of default by the U.S. government would have seen you laughed out of the room until recently, when the political fight over raising the debt ceiling focused the world on America’s $14 trillion government debt.

“We never even dreamed that a U.S. sovereign default could occur. That is what a triple-A rating is supposed to mean,” said Carl Weinberg, the chief economist at High Frequency Economics said in a research note on Friday.

“The reality, though, is that a default by the U.S. is a non-trivial possibility as soon as next week," he continued.

"This is why the United States is likely to lose its triple-A rating, and this is why we have to think about the unthinkable.

”With $90 billion worth of U.S. bonds due for redemption on Thursday, August 4, there is a chance if they go unpaid that those holding them will face a 100 percent loss unless investors are willing to let them roll over, according to Weinberg.

“This would be a big and immediate hit on banks' balance sheets,” said Weinberg.

The U.S. Treasury is reported to be working on contingency plans that would favor bond holders and avoid such an outcome, but the longer the deadlock in Washington continues, the higher the risk.“Notes and bonds pay coupons on the fifteenth and last day of each month.

A smooth extrapolation suggests about $540 billion of debt mandates some kind of payment in every bimonthly cycle, and the August 15 payment will likely be a big one because it is the month of the Treasury’s quarterly funding exercise,” said Weinberg.

“The potential hit is big enough that banks have to start thinking about how to deal with the contingencies or risk extinction,” he said.

“The world’s financial system could face losses equivalent to that of Lehman’s failure by August 15 and then again on the fifteenth day and the last day of every month until default is rectified,” said Weinberg.

The reality of such a situation according to Weinberg would be the failure of the world’s banking system while the Federal government is shut down, with catastrophic results for the domestic economy : “World trade and exports would collapse."

One option for the world’s central banks would be to change regulations so that banks do not have write down their Treasury holdings right away, according to Weinberg, who believes cutting rates and quantitative easing would be the order of the day in every major country on the planet if the unthinkable actually happens.

Central banks would have to pump liquidity into the system to avoid a complete collapse of the financial system and a global depression.

The U.S. is still more likely not to default than to default, Weinberg said, but like many of his peers he believes a downgrade of U.S. debt is now assured.

“A downgrade means that the yield the United States has to pay to sell its debt will rise.

This will raise the cost of borrowing to almost every financial institution around the world by raising the cost of funding U.S. dollar positions.

De facto, this is an interest rate increase,” said Weinberg.

“Now is the time to start writing the book on how the world changes, and what central bankers ought to do, when the world’s reserve currency fails," he said.

"It will not be a comedy.”