Roundtable: Will the U.S. Default?

We're in the dog days of summer, but traders and hedge fund managers will have to put off their retreat to the Hamptons until later. This year, several unanswered questions hang over global financial markets like a sword of Damocles -- none perhaps more pressing than whether or not Congress will raise the federal debt ceiling by early August. If not, the U.S. will risk defaulting on its obligations.

U.S. Treasury bonds are the global risk-free benchmark; anything that unsettles markets' faith in that assumption -- even if it is only a technical default -- could create tremendous instability in an environment that looks highly vulnerable.

To consider the odds of that event, I asked two of the Fool's best "big picture" analysts, Morgan Housel and Dan Caplinger, to answer the question that is at the forefront of the markets' collective mind: Will the U.S. lose its AAA rating?

Morgan Housel: The history of countries defaulting makes it clear that they are political events, not economic ones. Countries default by choice when it becomes the least-bad option, not when the markets force their hand. If the U.S. does default, it will almost certainly be caused by something like the debt ceiling getting in the way.

That said, the odds are overwhelming that the ceiling will be raised. I don't think anyone actually believes there will be a default in the near future. If a vote doesn't raise the ceiling over the next week or two and the market starts getting suspicious, bam, that's when you'll see Congress act. Remember the fall of 2008, when Congress was debating the TARP bailout package? The first vote failed, and the Dow immediately fell almost 800 points, at which time politicians changed their minds and quickly passed the bailout. Something similar might happen this time. All it takes is one rumor that default risk is putting Citigroup (NYSE: C  ) or Bank of America (NYSE: BAC  ) in dire straits for the market to nosedive, and you'll probably see a deal cut that day. It's in nobody's best interest for the Treasury to default.

Dan Caplinger: Any time politics gets involved in an economic decision, it's impossible to say what will or won't happen with certainty -- no matter how catastrophic the consequences might be. The idea that a debtor nation that owes more than $14.3 trillion in outstanding public debt would voluntarily take steps to sabotage its own credit rating and thereby increase borrowing costs not only for itself but for every U.S.-dollar borrower in the world is preposterous.

Even if the U.S. does have a technical default, I don't anticipate investors having to worry about never getting paid. The likely worst case would be similar to what happened in California in 2009, where the state ran out of money and creditors received IOUs at fairly attractive interest rates. At first, big banks including Wells Fargo (NYSE: WFC  ) , Citigroup, and JPMorgan Chase (NYSE: JPM  ) even accepted the IOUs in lieu of cash, although later, they reversed that decision and stopped accepting them amid concerns about fraud.

Of course, the statutory debt ceiling doesn't allow IOUs, but it would be easy to pass legislation setting an interest rate for past-due Treasury debt. That might even lead to the creation of special markets for defaulted debt, just as Wall Street firms considered trading California IOUs two years ago. It will certainly get the message across to lawmakers that a default isn't worth the cost.

Alex Dumortier: I still think the odds of a U.S. default remain very low -- less than 2%, if I had to guess. However, that number is fundamentally unknowable, since the outcome is the product of human affairs. If people were rational, there'd be a degree of predictability to their actions, but it's difficult to make that case concerning our political leadership when one observes the spectacle on display in Washington. It's truly a case of the inmates running the asylum! Indeed, some of the lunatics are behaving as if a default is desirable.

Given the level of uncertainty this is creating, it's no surprise that different markets appear to be assessing the risk of default differently. The bond market, on the one hand, doesn't look one bit concerned, with the 10-year Treasury bond yielding 2.90%, near its 2011 low. Meanwhile, gold achieved another all-time (nominal) high on Monday, breaking $1,600 for the first time. Another precious metal, silver, has also gained strength recently, with the iShares Silver Trust (NYSE: SLV  ) up 16% since the beginning of the month.

My hope is that the Treasury bond market has a better read on the situation than precious metal buyers.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On July 19, 2011, at 10:30 PM, TMFFlushDraw wrote:

    This is the same as any public negotiation where negotiators are trying to get public sentiment on their side (see NFL lockout). If August 2 is the deadline I'm going to keep CNN and CNBC on mute until July 25 when the real talks begin.

    That's when the adults will step forward, we'll find out there's secretly been agreement on a lot of issues all along, and BAM a deal gets done before you know it. I think you're already seeing that happen but until there's really a sense of urgency nothing is going to get done. That's just the way the world works these days.

    Travis Hoium

    TMFFlushDraw

  • Report this Comment On July 19, 2011, at 11:43 PM, baldheadeddork wrote:

    I'm pessimistic about a deal. If I were betting on it, I'd put the odds against default at no better than 2:3. The numbers just don't work.

    Let's begin with a fairly obvious premise: Any bill that passes with majority support alone in one chamber won't have a prayer in hell in the other. The House Republicans would reject any bill passed by the Senate Dems without a lot of Republican support, and vice-versa. No bill will pass both chambers unless it pulls enough votes from both parties to offset the conservative and liberal base.

    There are 53 Democrats and 47 Republicans in the Senate. Within the parties, there is a block of several Democrats who typically vote with Republicans on fiscal issues. Two or three Republicans (Snowe, Collins, Murkowski) might vote with the Dems, but their votes are much less in play than the conservative Democrats.

    On one hand, even that level of aisle crossing improves the chance of getting a bill that has bipartisan support. But that's wiped out by the Senate requirement of 60 votes to end debate and bring a bill to the floor for a vote. As we've seen repeatedly since 2008, it's been incredibly difficult to get 60 votes on any contentious bill.

    Even if every Democrat votes yes, seven Republicans will have to vote yes just to get the bill to the floor. That's a tall order, and the odds are pretty good that all of the Democrats will not vote yes. Progressives like Sanders are in no mood to roll over on big Medicare/SS cuts, and conservative Dems like Ben Nelson will likely vote with the Republicans if there are any tax increases.

    Every Dem who votes no is one more Republican who has to vote yes for the bill to pass. That's why I think the actual crossover number for cloture is ten, and they'll need at least three Republicans to vote yes on final passage. That hasn't happened on any major bill since Obama took office. It will be really tough to get anything other than a clean extension to pass the Senate, and even that might require McConnell's ridiculously chickens**t proposal to get enough Republican support to pass.

    That's the good news. The bad news is that the House is much, much more difficult. All of the problems of the Senate are magnified in the House. The Republicans have a 48 seat majority, but Boehner will have to come up with a lot more than 25 votes. God Himself couldn't write a bill that Dennis Kucinich and Heath Schuler will vote for. My ballpark estimate is that regardless if the bill breaks left or right, Boehner will likely need to get 50 yes votes from Republicans to pass the bill.

    I don't see where he gets them. Morgan wrote that House Republicans got their act together after the Dow dropped 700 points in 2008. But the political lesson for Republicans was that they shouldn't have allowed it to pass. House and Senate Republicans who tried to defend their vote in 2010 were run out office in Republican primaries. They picked up 63 seats in 2010 and the cornerstone of their campaign was that nothing like TARP or ACA would ever happen again.

    Since they took over last January, they've done little more than pass bills that have zero chance of passing but hit all of the conservative buttons. I don't see that changing now. The base that elected them has made it clear that any surrender on raising the debt cap is unacceptable, and worse - an alternate universe media network continuously tells them that default wouldn't be a big deal and all the scare talk is just fearmongering from liberals.

    Boehner had a moment of raw honesty today when he said the "cut, cap and balance" bill is the only idea that could pass in the House. He's not playing this for effects. He doesn't have the votes, and he can't get the votes.

    Here's the really scary part: If arresting a 700 point plunge by voting yes on TARP was the darkest moment of the conservative movement, if not allowing the banks to collapse in 2008 was a mistake, what has to happen to get them to reverse course this time?

  • Report this Comment On July 20, 2011, at 12:37 AM, zombiedust wrote:

    I hate to say it but the US may default. Why? Because no one is going to expect it. Life never goes as planed. Look at the Casey Anthony trial. I'm still shocked at the verdict. I don't want the US to default but it may happen - to a certain extent. We have been going in the wrong direction since 2008. We have to cut spending, start saving, and paying off the debt - not extending it.

  • Report this Comment On July 20, 2011, at 12:41 PM, ahochau wrote:

    This is kind of like the guy that loses his job and decides that having the premium cable package and having a cup of starbucks every morning is more important than making the car payment or mortgage. Since there will still be revenue coming in and the revenue coming in is greater than the mandatory expenses, the only way the US will default is if congress and the president decide that the extras are more important that the obligations.

  • Report this Comment On July 22, 2011, at 4:51 PM, matthew2219 wrote:

    Why can't the Senate and House simply vote on the debt ceiling? A straight up and down vote with no stupid amendments would brand the morons who are playing with fire as irresponsible when they vote "No".

    But I am afraid that congressional rules would prevent such a vote.

    We need a new legislative model. One where the majority rules (with the Bill of rights in force for the benefit of the minorities) of and passage of laws is not subject to endless delay.

    We need 1) absolute term limits (1 term for any elected official); 2) with the proviso that Congress cannot pass any law for us that doesn't equally apply to them; 3) Limit their "pay" to expenses only; 4) a unicameral legislature; 5) no filibusters; 6) no endless studies, commissions, panels or other impediments to up and down voting; etc.

  • Report this Comment On July 25, 2011, at 7:25 PM, baldheadeddork wrote:

    @matthew2219:

    Congressional rules would _not_ prevent that kind of vote. In fact, that's how debt ceiling changes are usually written. It's literally a one-sentence bill that authorizes the Treasury to issue notes up to whatever the new limit is.

    I disagree about term limits. All that does is shift the power even further from legislators to the lobbyists and special interests - who never have to leave town. There are clear examples of this happening in state legislatures over the last couple of decades.

    I also don't like that it lets the voter off the hook for making a responsible vote, and working to get someone in office who does what they want.

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