The consequences of default on the national debt may be far worse than Congress knows. In fact, it’s hard to tell what Congress knows.
Congress must know that a default will most likely result in a credit downgrade and increase the interest rate on government borrowing, a needless increase in the cost of America’s debt service by hundreds of billions of dollars over the next decade or two. But there is so much more that could go wrong in a dimly understood and still fragile financial system. Does anyone in Congress have a clue, for instance, what the possible consequence might be of downgrading the asset used as collateral in untold trillions of dollars in global financial transactions? Before the Great Depression, America saw frequent panics and bank runs when depositors rushed to get their money out before the bank’s rumored failure. The result of widespread bank failures was often economic collapse and depression. The events that triggered the panics were rarely anticipated. New Deal reforms - safety and soundness regulation and deposit insurance - largely ended those old-fashioned bank runs by depositors. The newfangled shadow banking system, on the other hand, is disturbingly vulnerable to runs. The “shadow banking system” is an imprecise term for various forms of lightly regulated, typically short-term lending outside traditional commercial bank lending from customers’ deposits. Most shadow bank loans between financial institutions are couched as the sale of an asset with a contract to repurchase, usually the next day. The Federal Reserve estimates the scale of this “repo” lending at about $4.6 trillion on any given day, down 35 percent from the peak before the financial crisis. The financial industry argues that repo lending is secured and safe. The lender can keep the asset to satisfy the loan if the borrower fails to pay, so the asset is collateral. Any question about the value of the assets used, however, creates instability. When the repo market froze five years ago, largely out of concern for mortgage-backed securities used as collateral, Ben Bernanke and Hank Paulson came to Capitol Hill with fear in their eyes. The assets most commonly used for repo lending now are US Treasurys. On top of that, there are hundreds of trillions of dollars in open derivatives. US Treasurys are also collateral for many derivatives contracts. The catastrophic potential of a sudden flood of demands for more collateral should be obvious by now. American International Group would have collapsed without government intervention when the giant insurance firm’s customers demanded more collateral for credit default swaps, a derivative contract in which one party must pay the other if there is a default on a specific debt. AIG’s customers had the contractual right to require more collateral if bonds subject to credit default swaps looked shaky. Somehow, AIG never considered the possibility that they would, or at least not so many at once. MF Global, a derivatives trader, purchased Italian sovereign debt a couple of years ago at distressed prices with repo loans. The collateral for the loans was the Italian debt itself. MF Global’s calculation was that the Italian government would be good for the debt despite the market’s concerns. The firm stood to make a killing by holding the debt to maturity without default. The Italian government did not default, but the market became antsier about the possibility. MF Global’s shadow bank lenders demanded more collateral when the bonds declined further in value. The firm did not have more collateral and went bankrupt. “It’s hard for me to believe MF Global did not realize that it faced exactly this kind of risk,” financial blogger John Carney wrote at the time. “It’s very similar to the kinds of risks that brought down American International Group. How could they be so dumb?” Admittedly, S&P’s slight downgrade of US federal government debt two years ago produced not even a shrug from the shadow banking system and some fluctuation in the value of assets is inevitable. It would probably take a significant downgrade to have much effect. But what would be the consequence for the financial system if parties in a significant number of transactions secured by US Treasurys suddenly demanded more collateral? Most firms are not stretched as tight as MF Global or AIG, but some might be. And many firms might have to retrench, perhaps drastically. AIG’s and MF Global’s failure to anticipate demands for more collateral was perplexing, since they were thought to be smart and to have a sophisticated understanding of the financial system. Does anyone think that about Congress?