Fed Support
While some expect a 2013 default will drive up yields only on Treasury securities coming due, others including former Deputy Treasury Secretary Roger Altman see a wider impact in bond yields, pushing up borrowing costs.
“That would be higher interest costs over some considerable period of time for the U.S. and for U.S. taxpayers,” said Altman, who’s chairman of New York-based investment bank Evercore Partners Inc.
The yield on 10-year U.S. bonds dropped to a two-month low of 2.58 percent on Oct. 3. While short-term bill rates and the cost to insure against a default have risen, volatility in Treasuries has fallen, a sign that investor confidence in the Federal Reserve’s bond-purchase program is outweighing worries over the budget battle.
Some point to Standard & Poor’s 2011 downgrade of the U.S. credit rating, which led to an increase in Treasury prices, not a drop. Even after the rating was lowered by one level to AA+ from AAA, investors continued buying U.S. government bonds as they flocked to safety, according to Joe Davis, chief economist at Vanguard Group Inc.
A downgrade to default rating would be different, said Peter Tchir, founder of New York-based TF Market Advisors. Investors, structured vehicles, collateral agreements, derivatives contracts and other trading covenants have ratings- based rules that could force the replacement of Treasuries in a trade or portfolio, he said.
“Once the system starts to break down related to settlement and payments, then liquidity disappears, as we saw after Lehman,” Tchir said. “Perhaps the things we’re worried about now will be fine after a U.S. default, but who knows what others will not be.”
‘Create Chaos’
Treasuries are among the most popular forms of collateral pledged at derivatives clearinghouses, including the one owned by CME Group Inc., the world’s largest futures market. Government agencies such as Freddie Mac and Fannie Mae, which use interest-rate swaps and derivatives to hedge mortgage portfolios, would be affected by a downgrade because it could lower their counterparty ratings and result in more collateral being demanded by trading partners.
“We can’t even imagine all the things that might happen, just like Henry Paulson couldn’t imagine all the bad things that might happen if he let Lehman go down,” said Bill Isaac, chairman of Cincinnati-based Fifth Third Bancorp and a former chairman of the Federal Deposit Insurance Corp., referring to the former U.S. Treasury secretary. “It would create chaos in financial markets.”