Wall Street preparing for possible US debt default

US President Joe Biden and the Republican-controlled House of Representatives have been at an impasse over lifting the US $31.4 trillion debt ceiling, threatening to push the US government into its first debt default.

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Experts say that a debt default would be catastrophic for both the US and the global economy.

To avoid a default, Congress would have to lift the debt ceiling, but Republicans are demanding spending cuts to do so. President Joe Biden, a Democrat, wants a simple vote in Congress that would only deal with raising the government’s debt limit.

Since 1917, the US has had a law that sets a statutory limit on the total amount of debt that the Government is allowed to have. The limit was first set at $11.5bn.

The debt ceiling has been raised more than 100 times since 1917 and It now stands at $31.4 trillion. In January of this, the US government debt hit this level, which means that the Government cannot legally borrow any more money.

If the debt ceiling is not raised, US government expenditure will be more than its revenue from taxes, levies and others, as there will be no borrowing to argument tax revenues.

The US Treasury’s cash balance at the end of April was $316bn. “The question is when will that cash run out?. Treasury Secretary Janet Yellen says it will in June.

When this money has run out, the Government will only be able to spend the money that it receives in tax. It will therefore no longer be able to meet all of its public spending obligations, such as paying public sector salaries, or service all of its existing debt.

The first debt on the line is the US Treasury bonds which is due in June, and without the debt ceiling being raised, this might not get repaid.

Failure to avert a debt default in the US could have far-reaching consequences for the American and global economies, Treasury Secretary Janet Yellen warned on Tuesday.

“Every single day that Congress does not act, we are experiencing increased economic costs that could slow down the US economy… It is essential that Congress act as soon as possible… A US default would generate an economic and financial catastrophe,” Yellen warned.

Reuters reported that Wall Street banks and asset managers have begun preparing for fallout from a potential US debt default.

As the US government bonds underpin the global financial system, it makes it difficult to fully gauge the damage a default would create.

The financial markets are expecting massive volatility across equity, debt and other markets.

In its report, Reuters stated that Wall Street executives who have advised the Treasury’s debt operations warned that Treasury market dysfunction would quickly spread to the derivative, mortgage and commodity markets, as investors would question the validity of Treasuries widely used as collateral for securing trades and loans. Financial institutions could ask counterparties to replace the bonds affected by missed payments, said analysts.

Even a short breach of the debt limit they said could lead to a spike in interest rates, a plunge in equity prices, and covenant breaches in loan documentation and leverage agreements.

Short-term funding markets would likely freeze up as well, Moody’s Analytics was reported to have said.

Banks, brokers and trading platforms are therefore prepping for disruption to the Treasury market, as well as broader volatility.

The preparations includes;

How payments on Treasury securities would be handled,
How critical funding markets would react,
Ensuring sufficient technology,
staffing capacity
availability of cash to handle high trading volumes and
checking the potential impact on contracts with clients.

Big bond investors have cautioned that maintaining high levels of liquidity was important to withstand potential violent asset price moves, and to avoid having to sell at the worst possible time.

The Securities Industry and Financial Markets Association (SIFMA), a leading industry group, has put out an advisory in its playbook of what can be expected in the event that the debt ceiling is not raised.

The more likely would see the Treasury buy time to pay back bondholders by announcing ahead of a payment that it would be rolling those maturing securities over, extending them one day at a time. That would allow the market to continue functioning but interest would likely not accrue for the delayed payment.

In the most disruptive scenario, the Treasury fails to pay both principal and coupon, and does not extend maturities. The unpaid bonds could no longer trade and would no longer be transferable on the Fedwire Securities Service, which is used to hold, transfer and settle Treasuries.