Beyond a default: Catastrophic calculations

July 15, 2011

It’s easy to understand why the government will have more trouble borrowing if it fails to pay its debts. It’s a bit harder to see why ordinary Americans, the city of Pittsburgh, hospitals in Iowa, or medium-size corporations will have more trouble borrowing.

But they will.

And their trouble borrowing is the primary way a default, or even something too close to it for the market’s comfort, could deal a body blow to the economy.

It all comes back to U.S. Treasury bonds, which are the foundation of almost all other financial products — the base of the global financial pyramid.

If the federal government’s borrowing costs rise, so will everyone else’s. Mortgages rates will jump, car loans will be harder to come by, universities won’t be able to float bonds, cities won’t be able to fund themselves.

Treasuries are supposed to set the rate of “riskless return” — the price of loaning someone money and knowing, with perfect certainty, that they’ll pay you back, with interest. So when lenders decide how much to charge, they start with the riskless rate and then add to it to cover the risk that you won’t pay them back, and the inconvenience of having to wait for you to pay them back.

It’s a practice called benchmarking, and it’s everywhere: in your mortgage, your credit card, your car payments, the loan you took out to hire three new employees at your business. It’s even common internationally. The fact that Brazilian loans tie themselves to the American government’s debt just shows the high esteem in which the world holds us.

But if the rate on 10-year Treasuries rises, it means rates rise for everything else, too. That’s why economists consider the Federal Reserve’s power to affect interest rates — a power it has virtually exhausted during this crisis — so potent: if you can move the basic interest rate, you can move the whole economy.

“There’s a whole credit structure,” says Pete Davis, president of Davis Capital Investment Ideas. “Think of it as roads and bridges, but it’s finance, it’s all connected, and it’s all on top of Treasuries. . . . So when you shake the basis of it, everything on top of it shakes, too.”

Some sectors of the economy, of course, will be shaken harder than others. Benchmarking is just the most common way that the smooth function of the Treasury market affects everything else; it’s not the only way.

On Wednesday, Moody’s warned that they were putting the U.S. government credit rating on review for a downgrade. But they didn’t stop there. Another 7,000 debt products that are “directly linked to the U.S. government or are otherwise vulnerable to sovereign risk” were also put on review for a possible downgrade. That’s about $130 billion worth of debt. If America tumbles, so do they.

These are bonds that rely on payments from the federal government. Naomi Richman, a managing director in Moody’s Public Finance division, puts it bluntly: “There are certain kinds of municipal bonds that are directly reliant on Treasury paying or some other direct payment,” she says. “If those bonds don’t receive their payment, they have no other source of revenue.” If the federal government can’t pay its bills, down they go.

But Moody’s wasn’t done. An unknown amount of “indirectly linked” debt is also getting reviewed. That’s debt from state government, local governments, hospitals, universities and other institutions that rely, in some way or another, on payments from the federal government.

If Medicaid stops paying its bills, all the hospitals that rely on Medicaid’s payments become less creditworthy. If we stop funding Pell grants, then all the universities that enroll students who pay using financial aid become less creditworthy. And since the federal government passes one-fifth of its revenues through to the states, and the states pass those revenues through to cities, all of those governments would suddenly be in worse financial shape if the feds stopped paying their bills.

This is how a default gets into the rest of the economy: it destroys the fundamental trust that allows the financial markets to operate.

Running in the background of every day’s trading is the accumulated wisdom of an almost endless number of calculations: How much money does J.P. Morgan Chase have? How likely is Des Moines, Iowa, to pay its bills? What will interest rates be next year? How many people will buy homes in 2013?

These calculations undergo incremental updates almost constantly. That’s fine. Occasionally, they need to be dramatically updated. That’s manageable. But if they all need to be updated at once, and if no one really has the information to update them because Treasuries are suddenly unreliable? That’s catastrophe.

It was one thing to have forgotten that this sort of thing could happen in 2006, when America hadn’t seen it for 70 years. But we just went through it with the financial crisis, which was all about building a mountain of debt on a flimsy, subprime foundation.

If we go through it again, the Federal Reserve, which has pushed interest rates as low as they can go, and Congress, which has vastly expanded the deficit, have a lot less ammunition left for a response.

Are we likely to get to that point? No, of course not. But between here and there are worlds where the economy doesn’t crash, but the federal government panics the market, interest rates rise and the economy slows.

In a recovery this weak, that would be a disaster. And it would be entirely of our own making.

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