SBC Hearing on the Impact of a Default on Financial Stability & Economic Growth
At the October 10, 2013 Senate Banking Committee Hearing, members focused on the current political brinksmanship over lifting the debt ceiling and the potential fiscal and economic implications from defaulting.
Democrats largely focused their questions on the short-term and long-term fiscal and economic impact if the U.S. were to default on some or all of its obligations, the continued debate on lifting the debt ceiling and its effect on U.S. Treasury securities, and the economic cost of political gridlock.
Republicans focused their questions and comments on the long-term fiscal issues the U.S. will face in the near future, and whether there would truly be a default next week if the Treasury reverted to prioritizing payments on security obligations.
Notably, Sen. Elizabeth Warren (D-Mass.) advocated removing Congress’ role in raising the debt ceiling, the very threat of which “is costing us money and our good name,” and replacing it with the commitment that the Treasury can borrow as much as it needs to pay its obligations.
Sen. David Vitter (R-La.) was the only Republican senator to question the panel on the issue of prioritization of payments in the event of default. Sen. Pat Toomey (R-Pa.) was in attendance for the beginning of the hearing and did provide a short statement on the prioritization issue, but was absent for the Q&A portion of the hearing.
In his opening remarks, Toomey stated that “there’s absolutely no circumstances under which we should ever tolerate” choosing to miss a payment because of the important and unique role that Treasury securities play. Toomey said he was disappointed that Treasury Secretary Jack Lew “refused to acknowledge the obvious… that he would not choose to default on a U.S. Treasury security precisely because of the unique role that these instruments play.” He added that this would be the most disruptive of the “very unfortunate and very disruptive options that would be available.”
Testimony
In his testimony, Frank Keating, President and CEO of the American Bankers Association (ABA), urged Congress to meet its current obligations citing the fact that ordinary Americans “will bear the brunt of the damage” if the U.S. were to default on its debt for the first time in its history.
According to Keating, the U.S. is “much closer to disaster” than it was during the debt-ceiling standoff in 2011. If the U.S. was unable to pay its debts, “even for a few days, the consequences would be many times worse,” Keating stated, citing the fact that in the first two weeks of November, $345 billion in U.S. government bonds will come due.
In closing, Keating urged Congress to come to a bipartisan solution to address future spending levels and bring down the nation’s debt to sustainable levels. “Our role in the global economy is too important to flirt with the danger of default. Once trust is lost, it is difficult, if not impossible, to regain.”
In his testimony, Ken Bentsen, President of the Securities Industry and Financial Markets Association (SIFMA) focused his testimony largely on market preparedness in the event of default. Bentsen said SIFMA believes market participants “are operationally prepared to deal with the scenarios that a Treasury failure to pay would present.” However, since a U.S. default would be both unprecedented and “dangerously unpredictable,” no amount of planning can mitigate potential short- and long-term consequences of a default.
No default scenario “presents a clear cut answer,” Bentsen warned. “Indeed, the settlement arrangements for Treasury securities do not contemplate or recognize the possibility of a default and thus the ability to sell, finance, or post as collateral, defaulted Treasuries may be compromised,” he added.
Bentsen recommended that should Treasury announce it will be postponing a payment due to its inability to pay, processes including the U.S. Fedwire, clearing banks and the Depository Trust and Clearing Corporation’s (DTCC’s) Fixed Income Clearing Corporation “should be able to adjust to reflect changed payment dates” as the securities “may be transferred and can be sold, financed and, if acceptable to the counterparty, used as collateral.”
If an announcement were to come from Treasury beyond the time the above-mentioned systems normally run, Bentsen said “it is not clear how late [the] systems can be held and the potential consequences of any delay on the opening of the trading day in Asia.”
Towards the end of his statement, Bentsen discussed SIFMA’s efforts in developing an “industry playbook” to “provide key market participants and service providers a forum to share information about the latest developments including decisions from the Treasury, the Administration and Congress, and the status of the infrastructure and settlement providers.”
In his testimony, Gary Thomas, President of the National Association of Realtors (NAR), discussed the economic drawbacks to the housing market as well as the broader economy if the U.S. were to default on its obligations. Thomas described how a one percent increase in mortgage rates would decrease home sales by roughly 350-400,000 units, resulting in 700-900,000 fewer jobs. The Federal Reserve’s ability to support the housing market would also be affected as a decline in Treasury prices “could undermine the Federal Reserve’s ability to wind down its
purchases in an orderly fashion, potentially creating volatile movements in mortgage rates.”
In his testimony, Paul Schott Stevens, President and CEO of the Investment Company Institute (ICI), stated that the notion of a risk-free rate is in “serious jeopardy.” While the immediate threat is the current stalemate over the debt ceiling, Stevens cautioned that the U.S. Congress must not lose sight of the long-term U.S. fiscal imbalances. Stevens discussed the importance of investor confidence in the U.S. Treasury marketplace which will likely erode if the U.S. misses or delays payments, with dramatic spillover effects to the broader economy.
The United States, “like any other major debtor, must maintain the confidence of its creditors – or risk the consequences,” Stevens said. If the Treasury delays payments, “investors will learn a lesson that cannot and will not be unlearned… Treasury securities are not longer as good as cash – they carry a future risk of further missed payments.”
Question & Answer
Long-term Impact of Default
Chairman Tim Johnson (D-S.D.) opened questioning by asking the panelists for their views on the long-term impact of a U.S. default. Panelists all prioritized raising the debt ceiling over addressing long-term fiscal issues. Keating said whether the U.S. defaults “a little bit or a lot,” the impact will be “calamitous” either way. Bentsen said voluntarily defaulting on the nation’s debt “is something that doesn’t make any logical sense” and it would likely cause huge operational problems in the markets and could lead to a liquidity crisis if the U.S. were to default for some period of time. In the long-run, a default on current obligations would make resolving long-term fiscal imbalances “that much more difficult,” he added. Towards the end of the hearing, Johnson asked Bentsen about the impact to investors and current and future retirees if a default were to occur.
Bentsen stated that for investors in the short-term, if a coupon payment was missed “at least immediately they would be out money for some period of time.” It is unclear whether investors would be paid accrued interest from the due date or the date of actual payment, Bentsen said, adding that “if [investors] weren’t, they would have lost earnings associated with that.” In addition, as Treasury securities decrease in price, investors would take a loss on that as well.
Sen. Jack Reed (D-R.I.) asked about the difficulties likely to be experienced if the U.S. were to default. Bentsen replied that risk premium is already being priced into the market, especially
with regard to short-term treasuries and repo pricing. The pricing effect would likely be “exacerbated” if the Treasury was to miss a coupon payment and uncertainty would follow as it is not entirely clear “how you keep that Treasury security with the missed coupon payment transferable or pledgable as collateral,” or when that coupon will fully be paid.
Sen. Sherrod Brown (D-Ohio) asked whether it is possible that Treasury could unexpectedly see its balance dissipate by October 17 as bondholders request to be repaid rather than rollover their investments.
Panelists repeated that there is still a lot of uncertainty as to what the impact would be if the Treasury were to default and what the duration would be. Thomas discussed how, at some point in the near future, investors may not want to continue to lend, while Bentsen discussed how contingency plans are being developed and tested, but said in the end “we don’t ultimately know” how a default will impact the markets and the broader economy.
Prioritization of Payments
Johnson asked Stevens for his views on the possibility of prioritizing payments and whether this is a workable solution, to which Stevens replied that this approach “misses the point” as it would not engender greater confidence, would result in higher costs, “and makes the hole that you’re in just that much more deeper.”
In response to a question from Reed, Keating said community banks and large institutions are “very alarmed” because of the uncertainty and that “trying desperately to figure out who to pay first… is a crazy way to run the greatest economy the world has ever seen.”
The panel agreed to a question from Vitter that payments on U.S. Treasury securities should be the top priority if Congress was unable to extend the debt ceiling. However, Stevens stated that the negative effect on confidence in the U.S. Treasury market will be significant, and Bentsen questioned whether the Treasury has the operational capability to prioritize roughly four million payments that take place on an average day.
Vitter responded that the Treasury has two payment systems in place, one for securities obligations and one for everything else. He said he did not think it is a question of whether Treasury can pay its security obligations, adding that this should be the operational priority under a “bad scenario.” Vitter quoted Martin Feldstein, a Harvard economist, who said the U.S. government would not default as they collect enough in tax receipts each month to finance interest on the debt. Vitter then said, “I don’t think it’s accurate to talk about if we default next week because I don’t think there’s any chance of defaulting next week.”
Default Impact on State and Local Governments
Sen. John Tester (D-Mont.) questioned panelists on the potential impact to state and local governments if the U.S. Treasury were to default. Bentsen responded with concern regarding state and local governments that have refunded outstanding municipal or state debt and defused that debt using a treasury escrow. “If an escrow is affected by a Treasury security that’s deemed
non-eligible collateral, then that state or local government would be on the hook to make up any further shortfall in that escrow. So there could be a cash effect to state and local governments depending on how their escrow is structured.”
Bentsen added that banks are among the largest holders of Treasury securities and “if you affect the liquidity operations of a bank and their ability to pledge those securities, that’s going to affect their ability to put money out on the streets.”
Default vs. Long-term fiscal imbalances
Sen. Mike Crapo (R-Idaho) asked the panel whether the threat of default on U.S. Treasury obligations is greater due to the current political stalemate over the debt ceiling or because of the looming debt crisis. All panelists agreed that the two are linked and have to be addressed. Bentsen added that access to capital and credit markets will remain important if and when Congress decides to look into restructuring its fiscal imbalances. Bentsen cautioned lawmakers from impairing the ability to access these markets by failing to lift the debt ceiling. “I think you want to be careful not to make the long-term job any more difficult by not addressing the short-term issue.”