The price of distressed Treasuries | FT Alphaville

The price of distressed Treasuries

More and more folks are arguing (see Bob Janjuah, Caroline Baum, or Joe Weisenthal) that in the event of an imminent United States sovereign default, there’s only one thing to hold:

United States sovereign debt.

Prices will rise on scarcity value, essentially. On one reading, it’s simply a bet that the US treasury would prioritise coupon payments on the current stock of Treasuries, even as it’s prevented from new issuance for a time. There’s a deflationary logic to it too assuming the economy tanks on the snap withdrawal of fiscal stimuli. An event which (on this reading) panics Congress into raising the debt ceiling after all, thus making good on one’s canny investment before the US enters a prolonged default. (Let’s ignore for now that it’s increasingly likely the US faces a permanent loss of its AAA rating after the debt ceiling is raised anyway, and what this entails.)

We’re not convinced. At the very least, Treasuries are so unique an asset — and so deeply entwined with the financial system — that we think it’s a mug’s game to predict how they would evolve after such an extreme tail risk as the world’s safest credit lurching to sovereign default. But since FT Alphaville don’t mind being called mugs… we’d argue that the balance is if anything in favour of a forced fire sale of Treasuries.

Bondholder prioritisation without raising new debt is a nice idea, but it collides with the inconvenient truth that the United States runs a monthly fiscal deficit totalling $124bn, and that there are almost $60bn of T-bills maturing in the two weeks after August 2, all requiring redemption payments. (Plus a $20bn coupon payment on August 15 — Fitch has said this would be the trigger for restricted default, if missed.) So the risk of “accidental” technical default is hardly, to borrow a phrase from Moody’s, de minimis, even with bondholder prioritisation. There’s already a much bigger flaw in the argument anyway.

In fact, it ignores the vast role Treasuries serve as collateral – a role which usually sees them safely locked up in the day to day operation of the money markets, but which we already know is vulnerable to a sell-off — a Lehman, 2008-style margin spiral — in the event of the debt ceiling remaining in place. You’d hardly wait for ratings agency downgrades. It’s interesting to note than even before the Lehman or money funds stage of the storm of 2008, for example, Treasuries received haircuts of 3 per cent from prime brokers (chart from an old Bank of England presentation):

So what happens if they’re at the centre of the spiral this time?

JPMorgan observed in a note published a while back that the usual post-crisis haircut to Treasuries collateral has been 0.5 per cent, so could clearly damage leveraged investors if it suddenly rose – such as holders of MBS, who would then sell into that market, and so on. It’s not really the stuff rising Treasury prices are made of, we should imagine. (And again, we noted a while back that these haircuts were responses to volatility in the Treasuries market, not default.)

And in case you were to rationalise that this was ‘only’ a $4,000bn problem for private repo markets — it’s worth bearing in mind the following provision of the Federal Reserve collateral guidelines:

Unless otherwise indicated, securities must be rated investment grade and in some cases must be rated “AAA” (where indicated). If more than one rating is available, the most conservative (lowest) rating will determine whether the requirement is met

(H/T to Gary Jenkins of Evolution Securities, who’s been referring back to it quite a bit recently.)

So, there might be not just a sizeable surfeit of Treasuries in limbo from repo ineligibility and/or haircuts, but also a lack of safe harbour if even one ratings agency classes the US as defaulted. The collateral rules affect truly bedrock systems that shift huge amounts of assets, such as those used for intraday payments between banks (Fedwire). Again, do you hold, or sell, Treasuries in that scenario, if you can’t use them in these systems any longer and badly need (for instance) cash instead?

Of course we don’t know. And wouldn’t like to find out, as by that point in proceedings we’d be talking about ATMs drying up. It is however a very two-dimensional view of Treasuries to think they would have a simple safe-haven appeal in a debt ceiling crisis. It’s really a few short years since the experience of the shadow banking system’s collapse in the 2007-2008 crisis, another time in which no one realised the system’s collateral connections, or saw the freight train of fire sales coming.

We seem not to have learned very much.

Related links:
US Treasuries – they are a-changing – FT Alphaville
The AAA bubble – FT Alphaville
Unpredictable extremes of politics pose the real risk – FT