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Sheila C. Bair, who chairs the Federal Deposit Insurance Corp., warned in Friday's Washington Post of the financial crisis that could stem from mounting U.S. debt:

Eventually, this relentless federal borrowing will directly threaten our financial stability by undermining the confidence that investors have in U.S. government obligations. Financial markets are already sending disquieting signals. The cost for bond investors and others to purchase insurance against a default by the U.S. government rose markedly during the financial crisis, from an annual premium of less than 2 basis points in January 2007 to 100 basis points in early 2009, before falling to the current level of 41 basis points.

With more than 70 percent of U.S. Treasury obligations held by private investors scheduled to mature in the next five years, an erosion of investor confidence would lead to sharp increases in government and private borrowing costs. And while we enjoy a uniquely favored status today - investors still view U.S. Treasury securities as a haven during crises - events in Greece and Ireland should serve as a warning. The yields on their long-term government securities have risen from rough parity with U.S. Treasury obligations in early 2007 to levels that are hundreds of basis points higher. If investors were to similarly lose confidence in U.S. public debt, we could expect high and volatile interest rates to impose losses on financial institutions that hold Treasury instruments, and to raise the funding costs of depository institutions, which can be highly vulnerable to interest-rate shocks. All of us would pay more for consumer and business credit, and our economy would suffer.

There is one subtle point tucked away in this quote that I have insufficiently appreciated:

If investors were to similarly lose confidence in U.S. public debt, we could expect high and volatile interest rates to impose losses on financial institutions that hold Treasury instruments.

Let me spell out the logic:

  • As interest rates on mid-term and long-term U.S. Treasuries rise, the market value of the Treasury securities decline. Banks own $237 billion in Treasury securities, much of it consisting of long-term debt.
  • As the market value of Treasuries securities decline, U.S. banks, using mark-to-market accounting, suffer significant losses.
  • To preserve their required capital ratios, banks cut back on lending.

Thus, ripples from the growing investor distrust of sovereign debt generally, and United States debt in particular, could impact American businesses and consumers.

Boomergeddon draws nigh.

Disclosure: No positions

Source: Sheila Bair on the Next Financial Crisis