THE DANGERS OF A DEFAULT POSITION / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

JUNE 15, 2011

The Dangers of a Default Position

By RICHARD BARLEY

Associated Press

House Ways and Means Committee Chairman Rep. Dave Camp, right, with House Budget Committee Chairman Paul Ryan

The default debate has gone global: In both the U.S. and Europe, markets are confronting questions about the sanctity of government debt. If handled wrong, this risks triggering a fresh financial crisis.

European politicians and central bankers are at loggerheads over whether Greece's private creditors can accept changes to their terms without triggering a default. In the U.S., there is talk of a "technical" default on Treasurys if agreement cannot reached in Washington on raising the debt ceiling.

Reuters

A key risk from Greece is that a default of any sort would pile pressure on Ireland and Portugal.

The problem: If it looks like a default and smells like a default, it probably is a default. Using the word "technical" doesn't change the reality if some Treasurys aren't paid on time. The same goes for Europe. Even if banks "voluntarily" roll over their debt, it is hard to see that as truly an act of free will. Standard & Poor's downgrade of Greece to triple-C—making it the lowest-rated sovereign in the world—specifically fingers the latest German debt swap proposal as a default.

Europe's politicians may end up lending Greece more money, as the European Central Bank clearly opposes anything that resembles a default. U.S. politicians may agree to raise the debt ceiling from $14.3 trillion before the cut-off date of Aug. 2. Even after that, Treasury Secretary Timothy Geithner can prioritize outgoings to favor debt payments. But with a monthly budget deficit of $124 billion, according to Fitch, the risk to debt service will build quickly.

On Aug. 15, $52 billion of payments are due.
What if politics means bond payments stop?
A key risk from Greece is that a default of any sort would pile pressure on Ireland and Portugal, where debt dynamics aren't as bad, to follow suit. The ultimate risk is contagion upending Spain, whose €1.1 trillion ($1.59 trillion) economy is too big to bail out.
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In the U.S., there are three main channels through which financial turmoil can spread. First, short-term funding may be disrupted. As investor Stanley Druckenmiller argues, holders of long-dated Treasurys might accept a short delay in payments in exchange for the political face-off in Washington leading to a credible program for fiscal repair. But those holding maturing debt are unlikely to agree. For money-market funds, liquidity is everything: a failure to pay risks a new Lehman-like run.

Second, more than $4 trillion of Treasurys are used as collateral for repurchase agreements, futures and derivatives, J.P. Morgan Chase notes. A greater discount on this collateral due to increased credit risk could cause turmoil.

And third, while U.S. investors might stick with Treasurys, foreign lenders may see it as another reason, on top of the falling dollar, to reduce exposure.

There is one key difference between the two situations. Greek credit risk is real, given a soaring debt burden, loss of market access, shrinking economy and the country's inability to print euros. The default debate is necessary, although it has been poorly handled.

The U.S. default threat, by contrast, is unnecessary and threatens to introduce credit risk into what has been seen as the safest asset in the world— a dangerous development. With the global financial system still so fragile, this isn't the time for politicians to raise the stakes.

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