The X-Day
US Senate and the House of Representatives have just passed bill that ends the debt crisis.The deal will fund the government until 15 January and lift the debt ceiling until 7 February. But it is possible that, sometime near to the next deadline, the U.S. Treasury will exhaust its capacity to borrow. Let’s call it The X-Day. When the debt ceiling is hit, the Treasury would still have cash in hand, which would allow it to keep things going for a bit longer. To put it in perspective, in the first 11 months of fiscal year 2013 the Treasury has disbursed $293 billion per month, on average, which works out to $9.77 billion per day.
Payments are sometimes wildly off expectations: the monthly deviations between actual outlays and planned outlays ranged from 3 billion to 68 billion. Even worse, payments spike on certain days of the month, such as when the Treasury sends Social Security checks or pays interest on the debt. On November 1, for instance, it expects to make total payments of about $70 billion, due to a combination of Medicare/Medicaid and Social Security disbursements. Granted, the Treasury takes money in too. But the average monthly receipt falls well short of outlays, at $225 billion (vs. $293 billion in outlays). Receipts are also unevenly distributed across months and within each month, and are almost always off predictions.
Some takeaways from all this: First, there is substantial uncertainty about when the Treasury runs out of money, and there is a risk of miscalculation. Second, it is impossible to try to balance receipts and outlays on a monthly, let alone a daily, basis.
A Matter of Priorities
The following statement may seem obvious, but I’ll say it anyway: when the Treasury runs out of money and is unable to borrow, it cannot pay all the bills. Some Treasury payments would be either missed, only partially fulfilled, or delayed. The question is: which ones? A default would occur only if interest payments on Treasury securities are not satisfied in full amount and on time. Announcing that interest will be paid, but with a delay, is a default, at least in my book.
The buzzword of the hour is “prioritization,” i.e. the Treasury would pay interest on the debt, and make partial (or no) payments on salaries of government workers, Social Security benefits, fighter jets, and everything else. From an average cash flow perspective, it is feasible. During the first 11 months of fiscal year 2013, the Treasury made average monthly payments of $36 billion on interest, while pulling in receipts north of $200 billion. However, the Treasury would need to start saving up for those payments very soon before due. That means that, even before X-Day, the Treasury would need to stop paying some federal salaries, Social Security, etc.
Legally, it is not clear that this can be done. Several members of Congress were reportedly pushing for it, and a report by the Treasury inspector general relating to the 2011 debt ceiling crisis suggests that it is feasible. Another higher hurdle seems to be operational. The Treasury’s information systems may be unable to handle prioritization, because they are designed to make each payment in the order it comes due. Still, the system seems to also make bond repayments through a channel separate from all other payments. I wonder if it would be possible to “switch off” the other payments channel, while keeping the bond repayments channel switch on.
Politically, prioritization would prove a very short-term fix. It would not take very long for certain constituencies to revolt at the sight of “letting pensioners and disabled citizens starve,” while the Treasury keeps cutting big checks to China and to “the fat cats in Wall Street.”
My own opinion is that prioritization would be legally and operationally feasible. I also think political considerations make prioritization extremely unlikely.
The Magic Wand
Several bizarre solutions have been proposed to avoid a default if the debt ceiling is not raised in time. At the top of the totem pole of hare-brained ideas is the trillion-dollar coin. The Treasury cannot print money, but it is authorized to mint platinum coins, which are marketed to collectors. In theory, it could mint a coin with a nominal value of a trillion dollars and deposit it at the Federal Reserve. The Fed would then credit the Treasury’s account with a trillion dollars and, voilà, the Treasury would then keep cutting checks without incurring any debt.
I have not found any convincing technical arguments against this, except that it is an underhanded, dishonest, dirty trick. Its main drawback in my opinion is that it would undermine the credibility and independence of the Federal Reserve forever: if you think about it, minting this monster coin implies that the Treasury is printing money through the back door.
A second solution is to simply ignore the debt ceiling constraint. President Obama has not ruled out using the 14th Amendment to increase the nation’s borrowing ability. Some experts such as Bruce Bartlett, Garrett Epps, and former Treasury Secretary Timothy Geithner opine that the debt ceiling may be unconstitutional if it interfered with the ability to repay debt or any other obligations of the U.S. government. Other analysts disagree. The White House said on Thursday that they “don’t believe that the 14th Amendment provides that authority [to ignore the debt ceiling] to the president.”
The third solution is issuing “super-premium Treasuries.” It goes like this: Say that the Treasury has $50 billion of one-month Treasury bills coming due each month. Instead of rolling those treasuries it would pay off their face value by issuing 10-year notes or 30-year bonds with, say, a 20% coupon. Those bonds would be priced at a steep premium. (That is, assuming that the yield to maturity of the new bonds is not too different from the yield of on-the-run securities, currently at 2.7% for the 10-year and 3.8% for the 30-year.) At current rates, the 10-year note would be priced at around 250 ($2.5 for every dollar of face value), and the 30-year bond would cost around 380. If the Treasury sold an issue of 10-year notes with $30 billion in face value, it would raise gross proceeds of about $75 billion, and net proceeds of $25bn. The total par outstanding would even diminish—by $20 billion, after redemption of the $50 billion worth of one-month bills.
Of the three approaches I have cited to avoid a default if the debt ceiling is not raised, the super premium bond solution seems the most likely to me. Unlike the other ideas, it would come across as a benign technicality to most of the public. If used only for a brief period of time, it would have a small impact on the duration of the outstanding pool of securities. Super premium bonds would obviously cost more to the Treasury than one-month bills, but the cost of default seems, at present, incalculably higher.
Impact on Our Portfolios
So an obvious question is “what does this mean for my portfolio?” Well, probably not much. The worst case scenario— that the U.S. defaults with no evidence of compromise (meaning the President simply does not exercise his “put” by forcing a payment)—short-term rates will soar and risk assets will drop—both by potentially enormous margins. But at this writing, such an event looks quite unlikely. In fact, at the moment the S&P is holding firm, short rates are basically unchanged and 10-year and 30-year rates have actually risen a bit. This is not a catastrophe scenario.
Francisco Torralba, Ph.D., CFA, is an economist with Ibbotson Associates.
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