How a Default Could Unfold

As lawmakers continue to debate what it takes to raise the $31.4 trillion debt ceiling, America is edging closer to disaster.

So what happens if the U.S. fails to raise its borrowing ceiling in time to avoid a default, how major nations are preparing for that scenario, and how the Treasury will pay its debts. The question arises as to what would actually happen if it did not. lender.

It is difficult to say with certainty how this situation will unfold as it is unprecedented. But this isn’t the first time investors and policy makers have had to think “what if.” And they are busy updating their strategies to anticipate how this event will unfold.

Negotiators are having talks and appear to be moving toward a deal, but time is short, by June 1, the earliest the Treasury Department estimates the government will run out of cash to pay the full amount. It is unclear whether the debt ceiling will be lifted. Claim your bills on time, known as the “X date”.

Big questions remain about what could happen in the market, how the government plans to default, and what happens when US money runs out. Now let’s see how things play out.

Financial markets are becoming more volatile as the US approaches X-Date. Fitch Ratings announced this week that it will put the nation’s highest AAA credit rating up for review. Possibility of downgrading. Another rating agency, DBRS Morningstar, made a similar assessment on Thursday.

For now, the Treasury still sells bonds and makes payments to lenders.

This helps allay some concerns that the Treasury will not be able to repay all of its maturing debt, not just interest payments. This is because the government regularly conducts new bond auctions, where bonds are sold to raise new funds. The tender is designed to allow the Treasury Department to repay old debt while receiving newly borrowed cash.

This would allow the Treasury Department to avoid significantly increasing its $31.4 trillion debt outstanding, but it has taken an unusual step in the wake of the imminent debt ceiling on Jan. can’t do that. At least for now, cash is needed to avoid payment interruptions.

For example, this week the government sold 2-, 5- and 7-year bonds. But that debt won’t be “settled” until May 31, when the other three securities are due, meaning the cash has been turned over to the Treasury and the securities have been delivered to the buyer at auction.

More precisely, the newly borrowed cash will be slightly larger than the amount due. The Treasury has borrowed $120 billion in three denominations this week. About $150 billion of debt is due May 31, of which about $60 billion is held by the government due to past crisis interventions in the market, and it will eventually repay this portion of the debt itself will leave an additional $30 billion in debt. Cash is needed, according to TD Securities analysts.

Some of that could go toward a $12 billion interest payment that the Treasury Department has to pay on the same day. But as time goes on and it becomes harder to avoid debt limits, the Treasury may be forced to defer additional funding, as it did during the 2015 debt limit stalemate.

The US Treasury pays its debts through a federal payment system called Fedwire. Large banks have accounts with Fedwire, and the Treasury Department applies debt payments to those accounts. These banks then pass payments through clearinghouses such as market plumbing and bond clearing corporations, and ultimately the cash is deposited from domestic retirees into foreign central bank holders’ accounts.

The Treasury could try to avoid default by extending the maturity of maturing debt. Due to Fedwire’s structure, its contingency plan states that should the Treasury choose to postpone the debt maturity, it must do so no later than 10 p.m. the day before the debt maturity. It is defined by the industry group Securities Industry and Financial Markets Association (SIFMA). The group expects the maturity to be extended by one day at a time if this is done.

Investors are more nervous that interest payments on other debt could be delayed if the government runs out of available cash. The first big test will come on June 15, when notes and bonds with original maturities longer than one year will come due.

Ratings agency Moody’s said June 15 was the date it was most concerned about the government’s potential default. But it may help next month with corporate taxes pouring into the coffers.

SIFMA said the Treasury could not delay interest payments without default, but could notify Fedwire by 7:30 a.m. that interest payments would not be made by the morning. After that, the payment must be completed by 4:30 p.m. to avoid default.

When defaults are a concern, SIFMA will hold up to two conference calls the day before defaults occur and three more conference calls on the day payment is due, with representatives of Fedwire, banks and other industry stakeholders. are planning to hold Each call follows a similar script to update, evaluate and plan what will be deployed.

“I think we have a good idea of ​​what could happen in terms of settlements, infrastructure and plumbing,” said Rob Toomey, head of capital markets at SIFMA. “That’s the best we can do. to hold back.”

One of the big questions is how to determine if the US has actually defaulted.

There are two main ways the Treasury can default. You fail to pay interest on your debts, or you fail to repay your debts when the full amount is due.

This has sparked speculation that the Treasury Department may prioritize payments to bondholders over other bills. If bondholders are being paid, but not others, the rating agencies are likely to determine that the US has avoided a default.

But Treasury Secretary Janet L. Yellen has suggested that failure to pay effectively amounts to default.

Shai Aqabath, director of economic policy at the Bipartisan Policy Center, said an early warning sign that a default was imminent could come in the form of failed bond auctions. The Treasury will also closely track spending and incoming tax revenues to proactively predict when payment defaults will occur.

At that point, Yellen predicted that the U.S. would not be able to make all payments on time, and would likely issue an alert at the specific timing of announcing the contingency plan Yellen intended, Aqabas said. said Mr. pursue.

Investors will also receive updates through industry groups that track critical deadlines for notifying Fedwire that the Treasury will not make payments on time.

Defaults can lead to a chain of potential problems.

Rating agencies have said nonpayment merits a downgrade on U.S. debt, and Moody’s has said it won’t restore its AAA rating until the debt ceiling is immune to political brinkmanship.

International leaders question whether the world should continue to tolerate repeated debt ceiling crises, given the key role the United States plays in the global economy. Central bankers, politicians and economists warn that a default could send the U.S. into recession, with secondary waves of consequences ranging from business bankruptcies to rising unemployment. are doing.

But these are just some of the risks known to lurk.

“This is all uncharted waters,” Akabas said. “There is no playbook to follow.”

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