Wednesday, July 27, 2011
Imaging Armageddon: What Will Happen if the US Defaults?
"Those whose duty it was to watch over the safety of the country lived simultaneously in two different worlds of thought. There was the actual visible world with its peaceful activities and cosmopolitan aims; and there was a hypothetical world, a world 'beneath the threshold,' as it were, a world at one moment utterly fantastic, at the next seeming about to leap into reality-- a world of monstrous shadows moving in convulsive combinations through vistas of fathomless catastrophe." -Winston Churchill, "The World Crisis; Volume I, 1911-1914"
I saw a poll yesterday which indicated that Americans are roughly evenly split on whether or not a US sovereign default would be a major catastrophe. This is pretty shocking to me because it seems transparently obvious that this would be a major catastrophe for which most of the world is vastly unprepared. So here is a litany of events that will cascade if and when the US halts payments to creditors.
1.) America will be shut out of the international capital markets for some period of time. If you are known to willingly default, then people stop lending you money.
2.) An instant MASSIVE recession. Though many people have a vague idea that the deficit is large they do not quite fully understand the degree to which the government services they enjoy are debt financed or just how large a fraction of the economy those services have become. Hmm... I wonder how big that is... lets have a look at it on the official budget document (check supplemental table S-1 on page 171) So here are the facts: in 2011 the government will take in $2.174 trillion and spend $3.819 trillion leaving a deficit of $1.645 trillion. That is to say that this year of the services the government is providing, it is borrowing 43% of it or for every dollar the government took in taxes, it borrowed another 75 cents and then spent it. Another way to think of it is that this deficit is about 10% of GDP which is to say that one out of every ten dollars in the economy this year was funded by federal borrowing. Does that sound like a lot? It sure as hell is. This is why the Tea Party is so freaked out, we really are in a deep hole. Is this the right way out? Probably not. Because once we default all that borrowing will come to a screeching halt and we will have a contraction in the economy of roughy 10% of GDP at high speed.
For some perspective on this remember the “great recession” of 2007-2009? During that time the economy shrank by about 12%. Now imagine a similar level of economic chaos happening IN A DAY. That's what we're looking at.
3.) Holders of US Treasury securities will begin to sell them. The US Treasury market is the largest single asset class in the world. This means that organizations that have to save a large amount of money hold a lot of them. Specifically Central Banks who peg their currencies to the US dollar have MASSIVE holdings of Treasuries. They also have a mandate to not lose money another reason they have been in Treasuries, until now they have been thought of as virtually risk free. Once the US chooses to default those holders will be tempted to begin to liquidate their holdings. It won't be an easy decision because even after the US Treasury begins to default the value of these bonds will not go to zero. This is because everyone knows that the US will at some point want to try to borrow money again. In order to do that they are going to have to have some kind of settlement with the holders of the pre-default bonds for some nominal amount of money. The large holders of the bonds will, if they can statutorily, hold on to the bonds because they'll have a lot of negotiating power with the US government. The problem is, as people sell them, the large holders will have to take larger and larger losses and may decide themselves to sell. One particular problem they will face is that almost immediately they will have to take large losses because a trick of the CDS settlement process.
4.) CDS are “Credit Default Swaps.” These are basically debt insurance policies and just as you can buy them to insure the risks you have of a company defaulting you can do the same for a sovereign. Let's say I sell you a $1 million CDS on IBM and then IBM goes bankrupt. I'll have to pay you the difference between what he lenders are able to recover of their original loans through liquidating the assets of IBM and the $1 million. So lets say that after selling all the real estate and type writers the creditors get 20 cents on the dollar, I owe you $800,000.
So, when an issuer on which a CDS has been written defaults there is a mechanized process by which all the people who owe insurance payments pay all those who are owed payments. At the center of this process is a large auction. This is because it takes too long to figure out how much money is going to be recovered in a liquidation. So what ISDA, the group responsible for settling CDS does is it hosts a massive bond auction to arrive at the markets best guess as to what the recovery value should be and then uses that price to benchmark who owes what to whom.
Historically this has not been the case in a sovereign default. What would happen is that the large holders would hold on and try to negotiate the best terms possible from the defaulting government. This happened in Russia in 1998 and again in Argentina in 2001 the bonds might trade but thinly and most effort was focused on the negotiations. But now, ISDA arranges a massive auction which would force all holders of US Treasuries to instantly realize their losses. Remember also that at the same time as this auction is being held the Peoples Bank of China and the Saudi Arabian monetary authority are going to have to decide whether or not to sell their holdings. And then here is ISDA hosting a nice auction, or liquidity event for them. Needless to say this could get ugly. It is hard to imagine a world in which there is a US sovereign default, then an auction with mildly well capitalized vulture funds on the buy side and the largest central banks on the other. Something tells me prices will go down, a lot. When the PBOC et all blow out of their treasuries they'll probably be blowing out of their dollars as well. So we would have a simultaneous dollar crash and interest rate spike. This would be, shall we say, manifestly not helpful for coming out of a 10% recession.
5.) The most interesting aspect of this for me is that it would basically destroy the modern framework of theoretical finance. In the way that the law of gravitation is central to the modern understanding of physics, the Capital Asset Pricing Model or CAPM is central to an understanding of modern finance. Basically the CAPM says that all asset in the world are related to each other through their expected rates of return and the variance, or risk, associated with that return. The idea is that returns and risk should be positively correlated, that is to say the more risky something is the higher the return. This is enforced by the daily actions of markets. If I have two assets which have the same return but one is more risky than the other I'll sell the risky one and buy more of the less risky one. This action will push down the price of the risky asset and thus increase its return. I'll stop doing this once the return is high enough for me to be willing to take on that risk.
6.) In this way all assets are related to all others and all of this assumes that, at the base of it, there is a risk free rate. That is a rate of return on which there is zero variance. Once you have that rate you know a great deal more about the relative attractiveness of all the assets with non-zero variance. For the entire existence of the theory the markets have used the US Treasury rate as a proxy for that anchor risk free rate and have priced all, and I mean ALL, other risk assets at a spread to that risk free rate. This made sense because after all the United States has hundreds of years of continuous Constitutional Governance, is surrounded by oceans or nations it dominates militarily, has thousands of nuclear weapons and has legal taxing power over the most productive economy in the history of the world. Sounds pretty risk free to me, except for one small thing. It can CHOOSE to default. If it does it would be the financial equivalent of altering the gravitational constant. The theory which links all asset classes to one another will have had its bedrock assumption thrown out the window and will have to reconstitute itself.
That process will begin with sudden massive repricing of all the risk assets in the world as people realize that the world is actually much more dangerous than they had been thinking for the preceding fifty years or so. This will start slowly and will build at huge speed in parallel with the CDS auction/fire of Treasuries which will jack interest rates in the US to the moon, the collapse of the dollar which will jack commodity prices to the moon, and simultaneous with the 10% of GDP recession induced by the sudden withdrawal of US government spending.
It is, in short, the end of the world.