All across the world, asset managers, individual investors and government officials all are discussing how to respond if the United States defaults on its debt obligations, remote as that possibility may be. After discussing the market impact and options available to limit losses or possibly garner profits, many will pause to reflect and say “I can’t believe I am even having this discussion.” But the time for astonishment is over, they realize, and as the clock ticks ever closer to August 2nd, the conversation has become increasingly urgent. This is not purely hypothetical any longer.
The specific cause for this sense of surprise and disbelief among investors, managers and government officials is because while the United States has the means, many times over, to repay all of its debts in full and on time, the leadership of the United States may or may not have the will to do so. We have always assumed Treasuries are “risk free” because in the ordinary course, borrowers with the means to repay loans generally have the will to do so (if for no other reason because borrowers do not relish having their assets seized by creditors). But is this the correct analysis when it comes to United States’ borrowing? What the current debt crisis demonstrates is that the answer is possibly “no.”
Today, “risk free” does not mean what your finance professor taught you. In gauging whether a United States obligation will be paid in full and on time and in all circumstances, a lender must ask not simply whether the United States government has (or has access to) sufficient assets to make the payment. The lender must ask whether the legislative mechanism is sufficiently functional as to enable the United States Department of the Treasury to make timely and complete payments on government obligations. We must ask whether our leadership is competent and then try to quantify the answer.
That is not an exercise most market participants are comfortable with and traditionally it’s not an exercise that has ever been needed. In fact, looking at the relatively mild reaction to the debt crisis in the credit markets, it appears that this is not an exercise many participants are even starting to engage in, let alone act upon.
But some of us are starting to wonder. If “risk free” doesn’t quite mean what it used to, if there is an entirely new and non-quantifiable layer of analysis to superimpose on our investment decisions and if that new layer is not currently priced into most assets, is there a risk of a sudden adjustment in asset prices? The point is not whether the United States defaults or not. The point is that we are having this discussion and that alone implies our old conception of “risk free” is no longer valid.