You've probably heard statements by politicians and budget wonks alike that America has never defaulted on its debt and that the long-term consequences of a U.S. default are unknown. Both statements are untrue. In fact, the U.S. Government first defaulted on its debt in 1979, when the U.S. Treasury, citing an unprecedented appetite for U.S. debt by small investors, the failure of Congress to act on April's debt ceiling legislation, and a glitch in the Treasury Department's word processing equipment resulted in a technical default on T-Bills maturing on April 26th, May 3rd and May 10th.
Moreover, the aftermath of this "momentary default", in terms of the yield curve, is well known within academic cicles. Though the nominal amount was trivial (about $122 million, non-adjusted) in comparison to what was then the total U.S. Debt, the penalty was severe: A sharp increase of 0.6 percentage points (60 basis points) that triggered a persistent increase in T-bill rates that ultimately cost the American taxpayer an additional $12 billion in interest payments, as older debt was rolled over at higher rates.
However, the real threat to the financial system in the event of a U.S. default is not interest rates or the Pacific Tigers dumping U.S. debt, but the trillions of dollars in money market funds, OTC swaps, repos and credit default swaps that depend upon U.S. Treasuries for Tier 1 collateral. If anything, the financial system's dependence on the sanctity of U.S. debt has increased since the financial crisis, largely due to the implementation of Basel III. And though the second most used form of collateral for these transactions are mortgage-backed securities, the Fed's $85 billion a month MBS purchases and higher interest rates have dried up much of the available supply of these bonds, even as new issuance is projected to fall off by about $50 billion between August and December.
When Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) were taken into conservatorship by the government in 2008, the quality of mortgage-backed securities (and by extension, the markets that depended upon GSE-issued debt to function) was commensurately improved by the U.S. Government's commitment to backstopping the market. This effectively pulled the teeth of the ISDA triggered "credit event" when the default clause of the credit default swap provisions was enforced and those securities were sold at auction. But who will backstop the U.S. government?
In my view, the market has not priced in the probability of either a U.S government shutdown or a temporary default and is proceeding on little more than the blind belief that both scenarios are unthinkable, and therefore impossible. But the unthinkable happens all the time. The Great Depression was unthinkable. The Nixon Shock was unthinkable. The Crash of 2:45 p.m. was unthinkable. A little over 2 years ago, the idea that the U.S. could default on its obligations was unthinkable.
And yet, here we are.
In the absence of a clear negative signal from the markets, the impetus necessary for a compromise may simply not exist. Even the lesser of two evils -- a prolongued government shutdown -- could quickly reverse rapid QE-driven gains in stocks and ETFs such as Amazon (AMZN) if it decreases consumer confidence, as well as index ETFs such as (SPY), (DIA) and (QQQ).