What if Treasuries Default?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.  

My posse’s on Broadway
- Sir Mix-A-Lot 

de·fault /dih-fawlt/
Verb: Fail to fulfill an obligation, esp. to repay a loan or to appear in a court of law.

im·pos·si·ble /im-pos-uh-buh/
Adjective

1. Not able to occur, exist, or be done.
2. Very difficult to deal with.  

Fitting definitions, don’t you think?

On one hand, it seems quite impossible for the U.S. government to default on its obligations.  On the other, if they do it will be “very difficult to deal with.”

Last week, a client asked me to describe what I thought would happen if Treasuries defaulted.  Naturally and somewhat defensively, I launched into all the reasons I thought this wouldn’t happen.  But that wasn’t the point of the question.  The point was “what if it did?”

I admit to being a bit stunned and having to gather my thoughts as I hadn’t really put a great deal of energy behind this scenario.  A couple silent seconds, though, and I was ready to play the game.

First, we must understand what default means.  In the case of the bond market and simplifying a bit, it means to not pay whole or part of a bond’s obligation.  This applies to both interest and principal.

Second, we must also understand that Treasury bonds do not have obligations due every day.  In fact, most Treasuries only pay interest on the 15^th and end of each month and have maturities on those same dates.  Treasury bills, though, mature each Thursday and since they are discount securities, they don’t make coupon payments at all. So, hypothetically, there could be well over 20 days in a month where the Treasury does not have any obligation to wire funds to pay for its debt.

Given a sparse payment schedule, it’s likely the Treasury could announce a default before it occurs in order to see how the markets react.  If done in a press release, it might look something like this:

We’re Sorry 

Washington, D.C. – June 10, 2011 – The U.S. Department of the Treasury today announced that it will no longer make payment on U.S. Treasury securities to satisfy either interest or principal obligations.  This action will begin next Wednesday, June 15, when our next coupon interest payments are due. 

Despite the fact we are a significant part of the U.S. government, which owns the only right to print dollars with which we could use to make good on these obligations, we have decided to withhold payment for the time being.   

In short, we’re sorry. 

Ok, maybe that’s not exactly what it would look like.

When the markets open on Monday, June 13, Treasuries would trade considerably higher — in yield, that is.  Taking a wild guess, we are probably looking at yields between 30 and 50 percent or more, initially.  That’s a 90 to 95 percent drop in price on a 30-year bond. Non-government bonds would go “no bid” and the stock market would likely freefall like we’ve never known before.

Given your wish to guard against such a scenario, where should you place your funds? Well, bank stocks will likely go to zero — as faith in the system plummets — so bank accounts are out. Commodities and other investments to be obtained through the financial markets are a non-starter — there wouldn’t be anyone around to hold onto them for you.

Without a functioning payments system (due to the fact there wouldn’t be a working banking system), credit/debit cards wouldn’t work, and it’s possible merchants wouldn’t even accept cash as our currency plummets to the abyss. In this scenario, real assets are really the only place to be.*

If we should ever find ourselves with such a black Friday announcement, my guess is that it would be short-lived — as would the terms of those in Washington. Some may call this the classic “small probability with extreme negative consequences” scenario. I call it fantasy.

Though I am not one to give our leaders in Washington much credit for great insight into the financial markets, surely they understand the consequences of a default.

*Perhaps I owe an apology to the University of Texas Investment Management Company for my article a few weeks ago (http://www.svb.com/blogs/jmorgan/end-of-the-world/ ).  By taking physical delivery of $1 billion of gold, they might have been planning on this sort of Armageddon?  On the other hand, given their closet full of bullion is stored in a vault in New York, they would have to form some kind of tremendous solid posse to claim possession under this scenario!