Real Proponents of Default

Last week’s vote in the Greek parliament for austerity forestalled default, at least temporarily. The government will be able to roll-over its maturing obligations thanks to official support from the European Union and International Monetary Fund (IMF) and bank acquiescence to a plan to roll-over their exposure at below-market interest rates. Now that the Greek situation has calmed the markets, attention is turning to the potential for a default in the United States.

The potential that a sovereign default may arise in the United States from an impasse in debt limit negotiations is unique in that those lawmakers supposedly “risking” default are actually the ones taking the more creditor-friendly position. As outlined by Senator Pat Toomey in the Wall Street Journal five months ago, lawmakers seeking to extract spending concessions in exchange for a debt limit increase are not trying to hold creditors hostage. They are merely trying to use the debt limit as a mechanism to slow the growth of government, which has expanded by 20% since 2008. They argue that creditors should be paid first, with remaining resources used to fund government spending according to a prioritization schedule set by Congress or the President.

Observers of the budget standoff in the U.S. seem to have difficulty appreciating its novelty: those refusing to sign-off to a debt limit increase are the ones advocating more austerity, not less. When a sovereign default actually occurs, it is not because elected officials are seeking more austerity than is on the table; it is because the government decides that it would rather take money earmarked for creditors and use it for domestic spending. The Greeks rioting in Athens to protest the terms of the latest austerity package, for example, are not doing so because they believe the cuts to government spending are insufficient. They are protesting because they’d prefer default to additional cuts to government services.

This is precisely the position of the Obama Administration in the U.S. debt limit negotiations. If the cuts to government spending are too steep, the Administration would prefer default. Yet, this point is missed entirely by commentators seeking to explain why the prioritization of creditors’ claims is somehow anti-creditor. The argument advanced now is that prioritization (pay interest on the debt, allow other government spending to fall into arrears) is akin to a household deciding to stop paying a variety of bills and then trying to refinance its mortgage. The intuition behind this argument is that a household that is late on its credit card bills, phone bill, and cable bill is not likely to be able to refinance its mortgage (which is the equivalent of rolling over maturing Treasury debt).

The problem is that this analogy fails to appreciate that the opponents of a “clean” debt limit increase (i.e. one that’s not tied to spending cuts) are not trying to rearrange claims as much as they are trying to reduce them. A more appropriate analogy would be a household that cancels its credit cards, phone service, and cable service to generate the cash flow necessary to meet its mortgage payment. A household willing to endure these hardships would actually have an easier time refinancing its mortgage. This point was made in the sovereign debt context by Stanley Druckenmiller: creditors are not likely to worry if the mortgage check is a week late because the debtor was taking steps to make future payments more likely.

It should also be emphasized that while a technical default creates the potential for a very unpleasant situation if it triggers an International Swaps and Derivatives Association (ISDA) “credit event”, the actual fallout is far from certain. The biggest threat from a technical default is not that bondholders will suddenly sell their Treasury holdings in a panic, but that the collateral value of Treasury securities will be temporarily impaired. Over-the-counter (OTC) swaps and overnight lending (repurchase agreements or “repos”) are generally collateralized with cash or Treasury securities with other high quality securities also accepted as collateral under certain circumstances. In the event that a credit event were triggered, the fear is that the $4.8 trillion repo market and $28 trillion credit default swap market would be thrown into disarray, or that the money market mutual fund industry would be forced to recognize that its Treasury holdings were in default, causing a run. The panic created by these circumstances would be difficult to contain.

However, the only experience government has with a similar circumstance is encouraging. The second most widely used and accepted collateral for repos and swaps are the debt and mortgage-backed securities (MBS) of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. When the GSEs were taken into conservatorship in September 2008, it was regarded as a default by ISDA. CDS contracts were enforced, an auction was held to settle the value of claims, and buyers of protection received their distributions from counterparties. The technical default event did not result in a crisis or sudden fall in the collateral value of GSE securities because the government was increasing its support for the obligations. As Moody’s explained:

Would a U.S. technical default be met with the same reception? It depends largely on the extent to which budget cuts stabilize debt levels and reduce the probability of future default. But the most important similarity with the GSE situation is that the action would come in the context of efforts to strengthen repayment capacity.

As the International Monetary Fund (IMF) explains, a sovereign default is ultimately a voluntary decision. It generally comes when the primary account – current government spending minus current government revenue – is in surplus and the budget deficit is entirely accounted for by interest payments on the debt. In these situations, the government has a strong incentive to default if interest payments are too high because it can fund all of its existing spending through existing revenue. When the primary account is in deficit, default generally is less likely to occur because the government still needs external financing to pay its bills.

In the U.S., virtually the entire budget deficit is from the primary account, as the federal government does not collect enough tax revenue to fund two-thirds of current spending, let alone pay interest expense of 1.9% of GDP (see Table 31 in Annex). As interest rates normalize, the primary account will have to be in surplus simply to stabilize our deficit at 4% of GDP (based on 80% of GDP debt and 5% interest rates). If rates rise further, future deficits could be 5% of GDP even if federal revenues pay for every cent of that year’s government spending. At that point, concerns expressed about technical default in 2011 are likely to seem quaint.