Houston:
Convening war rooms, planning rapid bailouts and sounding alarms are some of the ways the major banks and financial regulators are preparing for a possible US debt default.
“You hope it doesn’t happen, but hope isn’t a strategy — so prepare for it,” Brian Moynihan, CEO of Bank of America, the nation’s second largest lender, said in a televised interview.
The doomsday schedule is in response to a lack of progress in talks between President Joe Biden and House Republicans about raising the $31.4 trillion debt ceiling — a new round of negotiations took place on May 16, 2023 Without a debt limit increase, the US cannot borrow more money to pay its bills – all of which have already been approved by Congress – and in practice that means a default.
What happens if a default occurs is an open question, but economists – myself included – generally expect financial chaos as access to credit dries up and borrowing costs rise rapidly for businesses and consumers. A severe and prolonged global economic recession would be all but guaranteed, further tarnishing the reputation of the US and the dollar as beacons of stability and security.
But how do you prepare for an event that many expect would trigger the worst global recession since the 1930s?
Prepare for panic
Jamie Dimon, director of JPMorgan Chase, the largest US bank, told Bloomberg he is convening a weekly warroom to discuss a possible default and how the bank should respond. The meetings are likely to become more frequent as June 1 – the date the US may run out of money – approaches.
Dimon described the wide range of economic and financial impacts the group must consider, such as the impact on “contracts, securities, clearing houses, customers” – basically every corner of the financial system – at home and abroad.
“I don’t think it’s going to happen – because it’s going to be catastrophic and the closer you get to it, the more panic you get,” he said.
Then rational decision-making gives way to fear and irrationality. Markets caught up in these emotions are chaotic and leave lasting economic scars.
Banks have not revealed many details about how they respond, but we can glean some clues about how they have responded to past crises, such as the 2008 financial crisis or the 2011 and 2013 debt ceiling confrontations.
One important way banks can prepare is by reducing exposure to government bonds – some or all of which could be considered defaulted once the US is no longer able to pay all its bills. All US debt is called Treasury bills or bonds.
The value of government bonds is likely to plummet in the event of a default, which could further weaken bank balance sheets. After all, the recent banking crisis was primarily prompted by a fall in the market value of Treasurys as a result of the sharp rise in interest rates over the past year. And a bankruptcy would only make that problem worse, with nearly 190 banks at risk of bankruptcy as of March 2023.
Another strategy that banks can use to hedge their exposure to a sell-off in government bonds is to purchase credit default swaps, financial instruments that allow an investor to offset credit risk. Data suggests this is already happening, as the cost of protecting US government debt from default is higher than that of Brazil, Greece and Mexico, all of which have defaulted multiple times and have much lower credit ratings.
But buying credit default swaps at ever-increasing prices limits a third important preventative measure for banks: keeping their cash balances as high as possible so that they are able and willing to deal with whatever happens in the event of a default.
Keeping the financial plumbing running
Financial industry groups and financial regulators have also engineered a possible default to keep the financial system running as well as possible.
For example, the Securities Industry and Financial Markets Association has updated its playbook to prescribe how Treasury market players will communicate in the event of a default.
And the Federal Reserve, which is broadly responsible for ensuring financial stability, has been contemplating a US bankruptcy for more than a decade. An example of this was in 2013, when Republicans demanded repeal of the Affordable Care Act in exchange for raising the debt ceiling. Ultimately, the Republicans capitulated and raised the limit a day before the US was expected to run out of cash.
One of the biggest concerns Fed officials had at the time, according to a recently made public record of the meeting, is that the U.S. Treasury would no longer have access to financial markets to “roll” maturing debt. While reaching the current ceiling will prevent the US from issuing new debt in excess of $31.4 trillion, the government still needs to convert existing debt into new debt as soon as it falls due. For example, on May 15, 2023, the government issued just under $100 billion in notes and bonds to replace maturing debt and raise cash.
There is a risk that there will be too few buyers at one of the government’s daily debt auctions, where investors from around the world bid for Treasuries and bonds. If that happens, the government would have to use its available cash to repay investors who have maturing debt.
That would further reduce the amount of cash available for Social Security payments, federal employee wages and countless other items on which the government has spent more than $6 trillion by 2022. This would be downright apocalyptic if the Fed couldn’t save the day.
To mitigate that risk, the Fed said it could act immediately as a last resort for government bonds, quickly lower its interest rates and provide whatever funding it needs in an effort to avoid financial contagion and collapse. The Fed is likely having the same talks today and preparing similar actions.
A self-imposed catastrophe
In the end, I hope Congress does what it has done with every previous debt ceiling fear: raise the limit.
These contentious debates about lifting it have become too mundane, even as lawmakers on both sides of the aisle express concerns about the growing federal debt and the need to rein in government spending. Even when these debates result in a bipartisan effort to rein in spending, as in 2011, history shows them to fail, as energy analyst Autumn Engebretson and I recently explained in a review of that episode.
Therefore, one of the main ways banks prepare for such an outcome is by speaking out about the serious damage that not raising the cap is likely to do not only to their companies, but to everyone else as well. This increases the pressure on political leaders to reach an agreement.
Going back to my original question, how do you prepare for such a self-imposed catastrophe? The answer is: no one should.
(Author:John W. Diamond, director of the Center for Public Finance at the Baker Institute, Rice University)
(Disclosure Statement: John W. Diamond does not work for, consult with, own stock in, or receive funding from any company or organization that could benefit from this article, and has not disclosed relevant affiliations outside of their academic tenure)
This article is republished from The Conversation under a Creative Commons license. Read the original article.
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