A U.S. Default Is NOT Automatic

Posted by Mark Jasayko, CFA, Portfolio Manager

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McIver Wealth Management Consulting Group / Richardson GMP Limited

The news over the last two weeks has suggested that if U.S. lawmakers are unable to pass an increase to the federal debt ceiling, the U.S. will default on its Treasury bond obligations.

Not so fast.

There is no law that stipulates that there will be a halt on maturing bonds being redeemed and on interest paid to current bondholders.

Instead, the scenario would be more like this:

The U.S. Treasury Department has three agencies which make payments to cover the cost of running the government. This covers almost everything including the wages of government workers, wages of military personnel, civil and military procurement, and interest on the bonds that it issues. Since they have not had to prioritize in the past, there is no existing method of prioritization. Because the debt ceiling has been perpetually higher than the amount of outstanding debt in the past, all these payments have been on autopilot over the years.

So, in the event of hitting the debt ceiling, the U.S. Treasury will probably have to manually prioritize expenditures. Jack Lew, the Secretary of the Treasury, and his staff will have to carry out these decisions. Jack Lew’s boss is President Obama. Therein lies the source of Obama’s panic. Hitting the debt ceiling would be akin to a hot, flaming ball landing in his half of the court. He will be forced to decide whether to keep things like the National Parks open, or to pay interest to the bondholders. Considering that some of America’s largest trading partners are significant bondholders, and that the Treasury will have to roll-over $3 trillion in maturing bonds over the next twelve months, they certainly don’t want to upset those bondholders.

So, with that, what are the chances of a default? Low.

That does not mean that it cannot happen. Back in the late 1970s, the U.S. bumped into the debt ceiling for a short-period of time but the ceiling was quickly raised. However, there was a glitch with some word processing software that bungled the administration of the interest payments and those payments were delayed. The bond market got hit has investors became unnerved. And, it took a number of months before bond prices rose back to where they were before the problem.

Barring some similar glitch, a default will probably be avoided at all costs and bonds should sail relatively smoothly through this period.

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