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Will they or won't they? US default looms

Published: 12:13PM Saturday July 23, 2011 Source: Reuters

  •  (Source: Reuters)
    Source: Reuters

American businesses, from Wall Street banks to major industrial corporations, are preparing contingency plans for a pair of once-unthinkable events: the United States defaulting on its debt and the loss of the nation's top AAA credit rating.

While most bankers, investors and executives still cannot imagine that politicians in Washington could be reckless enough to let the government run out of money to pay its bills on August 2, they can't guarantee that the game of chicken that has been played in recent weeks won't go awfully wrong.

Lawmakers and President Barack Obama need to agree to raise the current $US14.3 trillion legal borrowing limit by that date to avert a default but the decision is being held hostage to arguments between Republicans and Democrats about how to cut the US budget deficit.

And this morning (Friday evening UST), the prospects of an agreement suddenly dimmed when top US Republican, House of Representatives Speaker John Boehner, broke off talks with Obama, saying they had become futile because the US President was demanding an increase in taxes.

It all means that just as companies once formulated expensive backup Y2K plans just in case computer systems couldn't recognize the date January 1, 2000, investors are devising ways to cope with financial markets pandemonium if the worst happens and the government of the world's biggest economy runs out of cash.

Ringing in their ears are dire warnings from the guardians of the nation's financial well-being - Federal Reserve Chairman Ben Bernanke said only last week that a default would be "calamitous."

In some cases, bankers are delaying their summer holidays, while companies are making sure they have plenty of access to cash, and investors are being told to hedge their portfolios, with gold one favored asset for that.

"We've to some degree taken on a defensive posture. We are now at 10% cash with so much uncertainty. In April, we were at 2%," said Keith Wirtz, chief investment officer at Fifth Third Asset Management, with $18 billion in assets.

At Morgan Stanley in New York it is all hands on deck at a time when many traders might otherwise be expected to be off to the beaches and the lavish mansions of The Hamptons, a very short helicopter ride from the city.

"I can tell you that we don't have any empty seats on the floor," said Jim Caron, global head of interest rate strategy at Morgan Stanley in New York.

"That will absolutely be the case the week of August 2nd," he added.

"Even with summer, no one is out of here at 4:30."

Many are dogged by flashbacks to the financial chaos in September 2008 after the Lehman Brothers collapse, and the failure of lawmakers to pass legislation to authorize a $700 billion government bailout of the banks, which sent markets into a tailspin.

General Electric Co, which was hit badly by those events, has boosted its cash holdings and cut its long-term debt in the past three years to put it in a better position to withstand such events.

The largest US conglomerate now holds $91 billion in cash on its books and has $40 billion in short-term debt, compared with the $16 billion in cash and $90 billion in short-term debt it had three years ago.

"The main thing that we've done and it's not specifically for the discussion going on in the US about raising the debt ceiling or the European issue, is we just have dramatically increased our liquidity," said Chief Financial Officer Keith Sherin, in an interview.

"It's part of our stress test that we do with our team and our regulatory and board members to be able to operate the company in the event of a significant external disruption."

Industrial equipment giant Caterpillar Inc  is more worried about the impact on the confidence of its customers of Washington's debt and deficit arguments as it is about its own resilience, according to its Chief Financial Officer Ed Rapp.

He said the company has very diversified funding sources and strong cash flow.

"I think we're in a good position in the event you get some disruption for a period of time."

For investors it is all about hedging risk to a greater extent than normal, which means assets that will retain their value if the dollar, US stocks and US government bonds head south.

John Taylor, chief executive officer of the $8-billion currency hedge fund FX Concepts, said he believes gold, which is close to a record having surged over $1600 an ounce today (NZT), will trade higher for another two to three months.

Downgrade

The second previously implausible event - a one-notch downgrade in the United States government's credit rating - is quite possible even if the ceiling is raised in the next 11 days.

At least some of the biggest fund managers can't say they weren't warned.
  
This week, the head of Standard & Poor's sovereign ratings group, John Chambers, has gone on a so-called roadshow, meeting with major money managers and pension funds including California State Teachers' Retirement System in California, to discuss the agency's ratings outlook on the United States.

CalSTRS holds $7.87 billion in US Treasuries as of June 20.

"I left the meeting thinking, 'Yes, we will be downgraded,'" a fixed-income portfolio manager at a major investment firm in one of the meetings told Reuters on Thursday. "I think S&P is just trying to front-run and get us prepared."

The Obama administration has grown increasingly frustrated with S&P, accusing it of changing the goalposts in its downgrade warnings. In telephone calls to top S&P officials, the Obama administration has asked why the ratings agency keeps shortening its timeframe for long-term deficit reduction, according to sources familiar with the discussions.

S&P says the criticism is "erroneous."

Insurance

Treasury traders are trying to set themselves up to guard against heavy losses in the event of a spike in yields that could - in some views - follow a US downgrade.

They're also positioning themselves to make a little money if the US does default and other investors call in insurance protection against their US bonds.

In the repo market, a place where investment banks and companies can get overnight cash loans in exchange for Treasury bills used as collateral, traders were awaiting word from securities exchanges, including CME Group, the largest US futures exchange operator, and ICE US Trust, on possible cuts to the value of Treasury securities used as repo collateral.

None of the exchanges that handle repo trades have detailed their plans yet, but Jim Binder, a spokesman for OCC, the sole clearinghouse for US stock options. said his organization was waiting to see how the market reacted to a downgrade.

"Until we start to see that actual volatility, it's still an academic exercise, not a jump into action," he said.

Bernanke and New York Fed President William Dudley met today with Treasury Secretary Timothy Geithner to discuss the implications if the debt ceiling is not raised.

On Thursday, top Fed policymaker Charles Plosser said that the central bank is actively preparing for the possibility of a default.

The president of the Philadelphia Federal Reserve Bank said the US central bank has for the past few months been working closely with Treasury, ironing out what to do if the world's biggest economy runs out of cash.

"We are in contingency planning mode," Plosser said in an interview on Thursday.

"We are all engaged. ... It's a very active process," he said in the the most extensive comments yet on preparations for a default from a US official.

Plosser said there were very difficult questions to grapple with. For example, the Fed lends to banks at the discount window against good collateral. But what happens if US Treasuries no longer fit that bill?

"Do we treat them as if they didn't default, in which case we would be saying we are pretending it never happened? Or do we treat them as if they defaulted and don't lend against them?" Plosser said. "Those are more policy questions."

The Securities Industry and Financial Markets Association, the Treasury market's main trade group, is helping securities' firms' back offices tweak their systems to prepare for possible missed interest payments on Treasuries or a debt downgrade.

"We are working with our members, particularly on the operations side but in other areas as well, to identify any areas that may benefit from revised conventions/practice recommendations under various scenarios, but, there has been no great plan in place as this was never envisioned," said Rob Toomey, a managing director at SIFMA and the organisation's associate general counsel.

Some market participants can hardly contemplate what a default would be like. One trader at a primary dealer said: "outright default would be Armageddon. It would fundamentally alter the landscape globally."

He said the New York Fed had not reached out to his firm to make contingency plans.

"I think that is a very difficult conversation to have and you're probably not going to get a wide range of opinion on that," he said.

The market's favoured index of fear, the CBOE Volatility Index, has been at a subdued level, though after today's breakdown that might not continue.

It's just above 17, which is in line with its recent range. If it rises above 20 and approaches 30, it would suggest investors were getting sufficiently nervous about market gyrations to take out more protection against losses.

"Right now there's just a minimal chance of there being no deal, but never say never," said Dan McMahon, director of equity trading at Raymond James in New York, who was speaking before the Boehner announcement.

"If there was a default, good lord, we'd fall 5 to 10 percent right off the bat," he said of major major stock indices.

"It would be like October 1987, but it really doesn't even warrant talking about right now."

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