What Happens If the U.S. Defaults on Its Debt?

Day nine of the government shutdown. Still no end in sight. 

For 800,000 or so furloughed federal employees, this is tough. For most Americans, it's a mere annoyance. 

But that could change in the coming weeks. Unless Congress lifts the nation's self-imposed debt ceiling, the Treasury will have less than $30 billion cash on hand on October 17, which will be wiped out quickly. According to the Bipartisan Policy Center, the Treasury will owe a $6 billion debt interest payment on October 31, $43 billion in Social Security and Medicare payments on November 1, and $29 billion in interest due on November 15. That makes defaulting on our debt frighteningly real. 

Some say, no problem: The Treasury still brings in enough cash per year and per month to pay interest on the debt. But this misses the point that what matters is day-to-day cash flow. And there are plenty of days when the Treasury takes in far less than $10 billion in tax revenue. With reserves dried up and faced with an interest payment in excess of daily revenue, the country could indeed be forced to default if barred from borrowing more. This has little to do with deficits and lots to do with day-to-day cash-flow mechanics. Even immensely profitable companies utilize debt to bridge short-term cash-flow gaps.

The odds are still overwhelming that the debt ceiling will be raised and default avoided. But more serious investors are asking what was once an unthinkable question: What would happen if America defaulted on its debt? 

A group of Congressmen responded this week with a shoulder shrug. "I understand Wall Street makes their money on trading these Treasuries, but Main Street? This has no impact on them," said Congressman Tim Huelskamp. "I think, personally, it would bring stability to the world markets," Congressman Ted Yoho explained when asked why he won't vote to raise the debt ceiling. 

The U.S. hasn't defaulted on its debt in more than 200 years (save for a brief computer glitch in the 1970s). No one has any idea what will happen if default occurs because there is no precedent for it.

But to brush off a possible default as no big deal is outrageous. You don't need a deep imagination to picture it as something akin to the 2008 financial crisis on methamphetamine.

There are two things to keep in mind about Treasuries. 

One
The global financial system is built on credit. That's just the way it is. And credit needs collateral. Lenders prefer safe collateral, and Treasuries are considered the gold-standard, "risk-free" asset. They are basically the cornerstone of the global financial system. According to Bloomberg, at least $2.8 trillion in Treasuries act as collateral in short-term lending markets. 

Imagine you took out a $1 loan backed by $1 of Treasuries. You'll repay the $1 loan with cash you receive when your $1 of Treasuries are paid off by the U.S. government. But then, the government decides to default. Maybe it's only in default for a day or a week. But it means you can't repay your $1 loan on time. That means your banker comes knocking, forcing you to sell, say, your stocks, or your house. If you have nothing else to sell, the banker gets into trouble. Then his creditors come knocking. They want their money back. But your banker's assets are in Treasuries, too. Now those are in default. So your banker's banker is in trouble. And around we go -- until the credit market grinds to a halt, and you have an utter disaster on your hands. 

Multiply this scenario by a few trillion, and you can imagine it wouldn't be very pleasant. "Well, holy cripes," was all Wells Fargo chief fixed-income strategist James Kochan could say when asked about Treasuries being pushed from the collateral market. 

This is, effectively, what occurred in 2008, just with mortgage bonds rather than Treasuries. 

Those holding bad mortgage debt fared the worst in 2008, but financial pain spread throughout the entire financial system, and to areas that had nothing to do with real estate. The reason was fear. If the global financial system is built on credit, it is supported by trust. When you remove trust, people hide now and ask questions later. The system freezes. I don't want to lend to you because you might hold something bad, or be lending to someone who is holding something bad, or be lending to someone who is lending to someone who is holding something bad. So people just wait. Credit stops flowing, and as we learned in 2008, that simply devastates the economy.

Even in a default, Treasuries will eventually be repaid -- that's a major distinction between now and 2008. But a credit crisis doesn't need to last long to bring the house down. Lehman Brothers was well capitalized two days before it was bankrupt. 

Two
The second reason default is dangerous is the likely rise in interest rates that would follow. It's a good thing when interest rates rise because the economy is growing faster than before. That doesn't necessarily even cost the government more money in real terms. But when interest rates rise because the market is pricing in credit risk, that comes right out of our pockets. Your pockets. 

The list could go on: Not raising the debt ceiling would force the government to balance its budget overnight, almost certainly creating a new recession (Goldman Sachs estimates it would lop 4% off of GDP). It would strain foreign relations. It'd likely wallop the stock market. And make us look a bit silly, to put it nicely. 

"Fun Fact," someone wrote on Twitter yesterday. "There is no actual crisis necessitating this manufactured crisis." 

No one knows exactly what will happen if we default. It may, in fact be a minor event. But like Russian Roulette, I'm frankly OK not finding out. 

 

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Read/Post Comments (10) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 10, 2013, at 5:51 PM, xetn wrote:

    The biggest effect would be to unburden the taxpayers and no fool would ever loan the government again (at least in the near future).

    But I don't think for a minute that the US will actually default this time around because it is the same silly game they play every time we hit the debt ceiling.

    FWIW, the US government has defaulted before and it wasn't the end of the world.

  • Report this Comment On October 11, 2013, at 9:04 AM, TMFGortok wrote:

    "confidence" or Gold? At least if the world financial system collapses on a gold standard, people will still have something other than, well... air.

  • Report this Comment On October 11, 2013, at 9:26 AM, ershler wrote:

    xetn,

    The government will still take out loans, we will just pay more interest on the debt in the future.

  • Report this Comment On October 11, 2013, at 12:37 PM, tminister wrote:

    We bring in $250 billion in taxes every month, our interest payment is $20 billion. Am I missing something. My understanding of default is not making interest payments.

  • Report this Comment On October 11, 2013, at 12:42 PM, methylfenidaat wrote:

    I do agree that global financial system is on credit and it is not good to have things on credit.

    Thank you for sharing and please visit http://www.methylfenidaat.com/

    Thank you,

    Dr Alex

  • Report this Comment On October 11, 2013, at 3:40 PM, shartuga wrote:

    tminister, that same point was made to the sec of treasury who responded that they pay bills in the order they come in and do not prioritize. I'm sure this would be one of those crisis opportunities where the Presidents "maximum pain" strategy to discredit his foes would be applied regardless of negative impact on the country.

  • Report this Comment On October 11, 2013, at 7:32 PM, dlfleming2 wrote:

    Amazing how we can't even balance the annual budget...and the national debt keeps growing. How about a balanced budget amendment once and for all!

  • Report this Comment On October 12, 2013, at 9:46 AM, hammaknocka wrote:

    The stalemate in Washington is a result of a dysfunctional Federal Government. Had Congress and the Executive been performing their Constitutional duties and responsibilities, we would not be finding ourselves on yet another "brink". Aided and abetted by Senate Democrats, the President takes that as his leave to act without regard to Article I, Section 8 of the Constitution. Democrats are obsessed with a single payer health care system and are willing to subvert the Constitution to get one. http://youtu.be/SXgSKwYMnWo

  • Report this Comment On October 17, 2013, at 5:42 PM, dmiles2 wrote:

    I'm curious about your posting rules. I have submitted comments several times and have yet to see any of them posted. I have read section 7 of your Fool's Rules. What rule did I break?

  • Report this Comment On October 17, 2013, at 5:44 PM, dmiles2 wrote:

    Ahh, now that this is a dead article you will let me post? But when the comments are active and I use numbers from your own reference to refute your argument you won't.

    Where is the respect on your part?

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