Debt ceiling crisis: how a default could play out

The United States is drawing ever closer to calamity, as lawmakers continue to bicker over what it will take to raise the country’s $31.4 trillion debt limit.

That has raised questions about what will happen if the United States does not raise its debt ceiling in time to avoid a debt default, along with how key players are preparing for that scenario and what would actually happen if the Treasury Department does not. pay your debt. lenders

Such a situation would be unprecedented, so it’s hard to say for sure how it would play out. But it’s not the first time investors and policymakers have had to contemplate “what if?” and they’ve been busy updating their plans for how they think things will play out this time.

While negotiators appear to be moving toward an agreement, time is short. There is no certainty that the debt limit will be lifted before June 5, when the Treasury now estimates the government will run out of cash to pay all its bills on time, a time known as the “X date.”

“We have to be in closing hours because of the schedule,” said Rep. Patrick McHenry, a North Carolina Republican who is participating in the talks. “I don’t know if it’s the next day or two or three, but you have to join.”

Big questions remain, including what could happen in the markets, how the government is planning to default, and what happens if the US runs out of cash. Here’s a look at how things could play out.

Before date X

Financial markets have grown more nervous as the United States approaches the X date. While euphoria over expectations of rising AI profits has helped the stock market rally, fears linger over the debt limit. On Friday, the S&P 500 rose 1.3 percent, a modest 0.3 percent gain for the week.

This week, Fitch Ratings said it would place the country’s highest AAA credit rating on review for a possible downgrade. DBRS Morningstar, another rating firm, followed suit on Thursday.

For now, the Treasury continues to sell debt and make payments to its lenders.

That has helped allay some concerns that the Treasury won’t be able to service the maturing debt in full, rather than just an interest payment. That’s because the government has a regular schedule of new Treasury auctions in which it sells bonds to raise fresh cash. The auctions are timed so that the Treasury receives its new borrowed cash at the same time it pays off its old debts.

That allows the Treasury to avoid adding much to its outstanding debt load of $31.4 trillion, something it can’t do right now since it enacted extraordinary measures after nearing the debt limit on Jan. 19. And it should give the Treasury the cash it needs to avoid any interruption in payments, at least for now.

This week, for example, the government sold two-, five-, and seven-year bonds. However, that debt is not “settled,” that is, the cash is delivered to the Treasury and the securities are delivered to buyers at auction, until May 31, coinciding with the maturity of three other securities.

More precisely, the new cash being borrowed is slightly more than the amount coming due, and the complicated act of balancing all the money coming in and out points to the Treasury’s challenge in the days and weeks ahead.

When all the payments are accounted for, the government ends up with just over $20 billion in extra cash, according to TD Securities.

Part of that could go to the $12 billion in interest payments that the Treasury also has to pay that day. But as time passes and the debt limit becomes harder to avoid, the Treasury may need to postpone any incremental fundraising, as it did during the debt limit deadlock in 2015.

After date X, before default

The United States Treasury pays your debts through a federal payment system called Fedwire. The big banks have accounts at Fedwire, and the Treasury credits those accounts with payments on their debt. These banks then pass the payments through market pipelines and clearinghouses such as the Fixed Income Clearing Corporation, with the cash ultimately landing in the accounts of holders, from domestic retirees to foreign central banks.

The Treasury could try to avoid default by extending the maturity of maturing debt. Due to the way Fedwire is set up, in the unlikely event that Treasury chooses to advance the maturity of its debt, it must do so before 10:00 p.m. on the day before the debt is due, according to established contingency plans. by the trade group Association of the Securities and Financial Markets Industry, or SIFMA. The group hopes that if this is done, the expiration will be extended by a single day at a time.

Investors are more nervous that if the government depletes its available cash, it could stop paying interest on its other debt. The first big test of that will come June 15, when interest payments on notes and bonds with an original maturity of more than a year are due.

Moody’s, the ratings agency, has said it is more concerned with June 15 as the possible day the government could default. However, it may benefit from the corporate taxes that will flow into its coffers next month.

Treasury cannot delay an interest payment without default, according to SIFMA, but it could notify Fedwire at 7:30 am that the payment will not be ready by morning. You would then have until 4:30 pm to make the payment and avoid default.

If a default is feared, SIFMA, along with representatives from Fedwire, banks and other industry players, plans to convene up to two calls the day before a default occurs and three more calls on the day the payment is due, with each call follows a similar script to update, assess, and plan for what might happen.

“On settlement, infrastructure and plumbing, I think we have a good idea of ​​what could happen,” said Rob Toomey, SIFMA’s director of capital markets. “This is the best we can do. When it comes to the long-term consequences, we don’t know. What we’re trying to do is minimize disruption in what will be a disruptive situation.”

Default and beyond

A big question is how the United States will determine if it has truly defaulted on its debt.

There are two main ways the Treasury could default: to stop paying interest on your debt or to default on your loans when the full amount is due.

That has sparked speculation that the Treasury Department might prioritize payments to bondholders over other bills. If bondholders get paid but others don’t, ratings agencies are likely to determine that the United States has avoided default.

But Treasury Secretary Janet L. Yellen has suggested that any late payment will essentially amount to a default.

Shai Akabas, director of economic policy at the Bipartisan Policy Center, said an early warning sign of a looming default could come in the form of a failed Treasury auction. The Treasury Department will also closely monitor its spending and incoming tax revenue to forecast when a late payment might occur.

At that point, Akabas said, Yellen is likely to issue a warning specifying when she predicts the United States will not be able to make all of its payments on time and will announce the contingency plans she intends to follow. .

For investors, they’ll also receive updates via industry groups that track key deadlines for Treasury to notify Fedwire that it won’t make a scheduled payment.

A breach would trigger a cascade of potential problems.

Rating firms have said a late payment would warrant a downgrade of the US debt, and Moody’s has said it will not reinstate its Aaa rating until the debt ceiling is no longer subject to policy risk.

International leaders have questioned whether the world should continue to tolerate repeated debt ceiling crises given the integral role the United States plays in the global economy. Central bankers, politicians and economists have warned that a default would very likely send the United States into a recession, triggering waves of second-order effects, from corporate bankruptcies to rising unemployment.

But those are just some of the risks that are known to lurk.

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

Luke Broadwater contributed reporting.