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.