Financial industry representatives related this year to the Senate Banking Committee the impact that default would have on the financial markets. With regard to Treasury securities, SIFMA President, and former U.S. Representative (D-TX), Ken Bentsen testified that Treasury’s intention not to make a payment timely remains the key variable under all the scenarios reviewed. Given the limitations of the transfer mechanism for Treasury securities, he noted, failure to provide sufficient notification for a payment failure would prevent the security from being further transferred. Holders of such a security may have limited opportunity to sell it, finance it through repo or post it as collateral.
As a result of a late notification, a Treasury security on which a payment is not made may not be further transferable. Although SIFMA assumes that the missed payments will eventually be made, while the payment remains unpaid the holder of the security that expected its payment may not be able to sell the security or finance it in the repo market. Similarly, collateral and margin requirements at clearing houses and central counterparties may no longer be able to be satisfied with these securities.
Further, it is entirely possible that any escrow, collateral or margin arrangement involving such securities could result in them being deemed non-eligible and subject to replacement. Essentially, explained the SIFMA official, the holder would have a receivable from the Treasury that could not be further transferred and, overall some frictional decrease in liquidity in the market could be expected.
The impact could be widespread, he continued. Counterparties might begin to question whether other counterparties would be able to replace ineligible collateral. Disruptions in the Treasury repo market would further impact price changes on Treasury securities.
Treasuries are the world’s safest asset and the most widely used collateral for both risk mitigation and financing. Shrinkage in the financing market would further pressure rates as haircuts on Treasuries would increase, thus reducing financing capability and disrupting the collateral market because of margin calls throughout the financial system that would reflect the overall repricing of Treasury collateral.
Once Treasury fails to make a timely payment, observed Mr. Bentsen, markets will have to wait each day for Treasury’s indications as to its intentions for payments due on the following days. If this were to continue for any length of time, he emphasized, market participants would need guidance on missed payments as well as future payments on additional securities. In addition, coupon payments that are not paid will ultimately be paid to the holder of record of the security on the day the payment should have been made. Uncertainty on that payment would continue until payment is finally made.
Also, securities that are coming due in the short-term would be less attractive to hold and may become harder to finance as doubts about the payment of interest and principal when due would be more prevalent. Even if the debt ceiling were raised at the last minute, experience from the 2011 event suggests that securities that may be the subject of a default in the near future will trade at a premium and will be more expensive to finance
Municipal securities. According to the SIFMA official, there are specific issues with regard to the municipal securities market. A key interaction between municipal securities and Treasury securities involves municipal refunding transactions. A refunding typically occurs when interest rates have fallen since a state or municipality issued long-term bonds, and a borrower is able to achieve interest cost savings by refinancing bonds at the current lower rates.
When a refunding can be achieved before the old, higher-interest bonds can be redeemed early, the borrower invests the proceeds of the new, lower-interest bonds in Treasury securities, and the income earned from these investments is used to pay debt service on and eventually redeem the old bonds. When old, higher-interest bonds are fully backed by an escrow portfolio, they are said to be “defeased” or “escrowed” and treated as triple-A rated.
Mutual fund industry. Paul Schott Stevens, President and CEO of the Investment Company Institute, testified that funds registered under the Investment Company Act hold more than 10 percent of their assets in Treasury and U.S. government securities. Such holdings are pervasive, he noted, with 30 percent of mutual funds holding these securities. Equity funds rely on Treasury securities for cash management and liquidity. Thus, he concluded that the 90 million Americans invested in funds share significantly in the risks associated with a Treasury default.