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2nd August 2011: Financial Armageddon?

Tuesday, Jul 19 2011 by
10

Does the date in the title of this thread mean anything to you? If not, it should! It's the date the US hits its debt ceiling:

President Obama's talked of "Armageddon". To Treasury Secretary Tim Geithner - it's "catastrophic". The Fed chairman Ben Bernanke has warned of "calamity". Or, in the words of senior Republican senator Lindsay Graham: "What is calamitous is the path we're on as a nation. We're becoming Greece."

It's a week of breath-holding brinkmanship over America's debt limit - the President's given party leaders just five days to reach an agreement to raise the country's borrowing limit - or risk default when the current $14.3 trillion ceiling runs out on 2 August.

Whilst the political posturing has been proceeding apace, most commentators have been assuming that a last minute deal will be done. Though markets have been soft of late, they are not pricing in the consequence of a failure to agree to raise this ceiling.

This is where I could use the counsel of wiser heads: what would be the consequence of Congress failing to raise the debt ceiling - both in the short-term and looking slightly further ahead?  It's a fundamental assumption of most theories of investing and asset valuation that US treasuries are a "risk free asset" and other debt tends to be priced relative to the "risk free rate". What happens if treasuries turn out not to be risk free? Is there a chance that the US could actually default?

 

Is it time to start piling up those cans of beans, shotguns, and gold bars? I guess the odds of the worst happening are slim and a last minute deal is likely to be done, but ISTM that we ought to consider the improbable case. Even if a deal is done at the very last minute, things would probably get "hairy" in the markets, to say the least, in the final run-up to the deadline. We could easily see a panic sell-off. Time to start thinking the unthinkable...

Thanks for any useful comment!

Mark


Filed Under: Economics, Politics, Debt,

Disclaimer:  

The author may hold shares in this company, all opinions are his own and you should check any statements that appear factual and not rely on them before making an investment decision. The author is NOT a qualified analyst nor authorised to give investment advice. Whilst the author is a director of ShareSoc, all views expressed are entirely his own and not necessarily those of ShareSoc.


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118 Posts on this Thread show/hide all

marben100 19th Jul '11 1 of 118
1

Ah - found an FT article I was looking for

...But any failure to raise the debt ceiling that ultimately results in a Treasury default could spark severe consequences in the crucial plumbing system that underpins global finance, given the central role played by US government bonds.

“As practically all parts of the global financial system from governments and central banks to companies and investors hold Treasuries for reserves or for security, the system would be at risk of collapsing,” said Carl Astorri, global head of economics and asset strategy at Coutts.

Treasuries are widely used as collateral for cash loans in the repurchase, or repo, market. On Friday, the Securities Industry and Financial Markets Association held a meeting with staff from the big banks to discuss operational issues that could arise in the event of a default...

...so banks are starting to think the unthinkable.

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sawney 19th Jul '11 2 of 118
3

Although the official date for the debt ceiling is 2nd August, ISTR from an interview on Bloomberg, that a deal really has to be struck by this friday to allow for the formal approval to be passed through Congress etc in time for the deadline date.

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emptyend 19th Jul '11 3 of 118
4

This is where I could use the counsel of wiser heads: what would be the consequence of Congress failing to raise the debt ceiling - both in the short-term and looking slightly further ahead?  It's a fundamental assumption of most theories of investing and asset valuation that US treasuries are a "risk free asset" and other debt tends to be priced relative to the "risk free rate". What happens if treasuries turn out not to be risk free? Is there a chance that the US could actually default?

"Unthinkable" isn't so far from the truth here.  This is perhaps a time to invoke the war-time opinion of Winston Churchill:

"America can always be counted on to do the right thing, after it has exhausted all other possibilities."

.....the US is of course adept at political brinkmanship, thanks to years of practice, so one cannot expect any deal to turn up before it absolutely has to....though I think one can count on some sort of fudge or another (yesterday it was being suggested that a deal could be done to remove the congressional veto and hand the powers clearly and squarely to the President in the short term - then it would be his problem).

"The right thing"  in this case is of course to get the deficit under control....though the US electoral cycle may mean that can't be properly done for another couple of years?  In the meantime, just to address Mark's point about "yes, but what if".....

....if the ceiling isn't raised then some debt couldn't be repaid when it fell due, creating a default. The immediate consequences would be a falling USD, rising precious metals prices and rapidly-rising bond yields in the US (with some damage elsewhere too). There would be rapid knock-on effects in other markets.....generally causing falls because of the huge rise in uncertainty. Paradoxically, the more stable, multi-national, companies in the US may actually see their share prices rise in USD terms (because their earnings are worth more in USD terms and they would be more competitive re exports) but growth companies and most others would suffer falls due to uncertainty and higher discount rates on future cashflows.

In short - it wouldn't be a happy scenario.

cheers

ee

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AbAngus 19th Jul '11 4 of 118
10



I have limited understanding of banking and so the following comments should be read with complete disdain where necessary. They are, at least, free of pre-conceived notions.

Is there such a huge pressure of unsustainable debts in the world that there will be earthquakes? Yes, I think so. Will there be Armageddon? No - I am in the camp that sees the pressure being eased through lots of shocks and aftershocks, some of which may be pretty large. 'This is the way the world will end: not with a bang but a whimper.'

But, supposing the Armageddon scenario occurs and the US defaults. Then:

1. There will not just be a crisis of liquidity around the World's financial institutions but also of solvency. Supposing all the banks go bust - then the working capital of companies (and individuals) would be frozen. The world stops.

2. No government could let that happen. Ergo, they would nationalise the banks and print enough money to cover deposits. Pay packets and bills will be paid. In a sense it would become a 'money' crisis - the man on the street might initially wonder what the problem is. (Where have I seen this in the last couple of years...?)

3. There would be huge long term implications for pension funds, property markets and so forth. I guess there would be a deep and long depression (and I am depressed enough as it is!) - but food would still reach Tescos and electricity would not be cut off. Paradoxically, some people would make fortunes. (I wish I knew how - I am not brave enough to short the world.)

4. In short, even if 'Armageddon' happens, I don't see it as 'Armageddon'.


What of the repeated shocks theory?

A. I think that Greece must default some time and the Sovereigns will take a 65% haircut. I just cannot see the other indebted nations being happy seeing 'Greece get away with it' unless they too can default - so I think contagion and further shocks are inevitable.

B. This creeping death may be worse than the Armageddon scenario above. Banks may wither on the vine without all of them actually dying - liquidity will dry up and no-one will know where they stand - and governments may not step in with enough authority. (Politicians hate taking responsibility.)

But - WTFDIK? Either way, I am in oil companies because I think the world - and especially the Far East - will survive. I am not sure that cash is really that safe......

Also, I have a small farm - I can always eat my cows. Or preferably my badgers. (Just a joke - really!)

AA

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marben100 19th Jul '11 5 of 118
2

When people use the words "unthinkable" and "impossible" in the context of financial markets, I get worried. Unfortunately I've seen too many "unthinkable" things, aka "black swans" happen in my investment career, though, of course nothing on this scale (I suspect it would make Lehman's failure look like a picnic).

I'm trying to understand in a little more detail what will happen if a bill fails to be agreed (as sawney points out) by the end of this week. I suppose we have a couple of weeks of limbo, whilst the world's financial markets try to do the exercise I'd like to do now, and digest the consequences of the debt ceiling not being raised on the 2nd.

Firstly it is not clear to me that a failure to raise the debt ceiling would result in a rapid default. Can the Fed "print money" to pay govt debts? Are there assets that could be sold? There is certainly talk of other govt expediture being curtailed so that an actual default is avoided (though this could only continue for a limited period, maybe months at most). However, I guess that such a failure would result in an immediate downgrade from the rating agencies, who already have a host of securities on credit watch negative in the event of such inaction. That would have severe and immediate consequences in itself, even without actual default. Any thoughts on what the conseqences of a downgrade of the US sovereign would be? Some are expressed in AV here.

I guess there is a strong chance that such an effect would result in another freeze of the global financial system, with counterparties not knowing who they could trust and hence being unwilling to extend any credit to anyone. World leaders would assemble and decide what to do, to stop the global economy and the financial system from collapsing. What practical choices would they have? Could we see a selective imposition of exchange controls?  Restrictions on withdrawals from banks? What would the consequences be on sterling and on the euro? Most significantly, how would China and other BRICS react? As one of the largest creditors, China would clearly not be a happy bunny. What would OPEC and other oil producers do? Would they continue to be happy to accept US$ in payment (do they have a realistic choice?).

It strikes me that there could be all sorts of non-obvious second order effects and that it would be worthwhile to try to identify some of these.

Having said all that, I agree with ee and most commentators that it seems unlikely that the US would actually be so stupid as to throw itself off a financial cliff. I am, however, wondering whether this might be a good time to buy some well out of the money index puts (covered warrants), on a short-term basis... just in case. I've calculated this would cost me 1-2% of my porty value, at most. Might help me sleep better at night. OTOH, in such an extreme eventuality could my counterparties (SG and RBS) actually be trusted to pay out??!!

Cheers,

Mark

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marben100 19th Jul '11 6 of 118

In reply to AbAngus, post #4

Hi AA,

I agree that a financial crisis doesn't stop the world from turning. Ways and means would be found to permit daily life to continue. However, I'm not as sanguine as you about the consequences for stock market investments, including oil companies. Short term, the "armageddon scenario" could lead to a freeze and collapse of markets as various parties are forced to liquidate assets. We've seen that type of indiscriminate selling before.

Secondly, the type of "depression" you foretell (which is a possible consequence) would probably lead to demand destruction, which we've also seen before, with a consequent effect on oil prices and oil company valuations (in the short/medium term). This would be exacerbated by traders being forced to unwind positions. Mind you, as in my previous post, I wonder what currency oil prices will then be measured in?!

 

Exactly what does a badger taste like? :0)

Mark

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tournesol 19th Jul '11 7 of 118
3

Just listened to a discussion on Radio 4's news programme about this subject.

The view expressed was that the measures necessary to avoid default would be taken. But the credit rating of the US government would probably be downgraded despite that.

So I guess that introduces a third option into the either/or debate.

It's not simply thatf Armageddon would result from default and Nirvana from avoiding it, there will be consequences from any downgrading - ripples from the event whatever the event is....

So how to avoid one's little investment boat being rocked too vigorously?

This links back to discussions about the safety of cash. ITSM that at times like this cash is a lot easier to hold than assets which can only be realised if you can find a) an efficient market b) willing buyers

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Mattybuoy 19th Jul '11 8 of 118
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The Fed cannot monetise debt over the ceiling i.e by buying Treasuries. However, that doesn't mean that there aren't other ways of doing QE e.g. by monetising private debt or other shims.

Zerohedge is probably the best place to understand all this stuff, it's not an easy read though.

FWIW I have zero doubt that a deal will be done.

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marben100 19th Jul '11 9 of 118
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In reply to tournesol, post #7

Hi T,

See my post above and the AV article it links to re consequences of a US downgrade - which I agree is a more likely outcome, but still a very serious one. Perhaps we shoud focus more on that scenario?

I have considered the idea of reducing my holdings/going to cash - but in a situation where cash remains accessible/usable without restrictions (i.e. anything other than a variant of "Armageddon"), I imagine that covered warrants would equally hold good (the"covered" part of the name means that they are supposed to be collateral backed, guaranteeing to pay out, barring a default of the counterparty).

The most likely scenario is that deals are done and things get "worked out" - not exactly a "nirvana" but means that things can rumble along pretty much as they do now. In that scenario I most certainly don't want to sell/reduce my holdings, as I wouldn't be holding them if I didn't think they were already undervalued or had considerable potential upside from near(ish) term events.

As you can tell, I'm leaning towards taking out some "insurance"... just in case.

Cheers,

Mark

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marben100 19th Jul '11 10 of 118

In reply to Mattybuoy, post #8

OK Mattybuoy - good idea to checkout Zerohedge (though IMO zerohedge has a certain slant)... I'm starting to think I'm asking an unanswerable question - and maybe T's approach is not so dumb: http://www.zerohedge.com/article/soros-goes-75-cash-fed-no-longer-telegraphing-trades

Earlier today we saw what happens to investment banks when the Fed no longer clearly telegraphs its intentions vis-a-vis which asset has to be frontran (see Goldman post earlier). It is not just banks. In the absence of the Fed semaphore, it turns out even such "legendary" hedge funds as Soros' $25 billion Quantum are about as clueless as everyone else. Bloomberg reports that "the fund is about 75 percent in cash as it waits for better opportunities, said the people, who asked not to be identified because the firm is private." The reason: "“I find the current situation much more baffling and much less predictable than I did at the time of the height of the financial crisis,” Soros, 80, said in April at a conference at Bretton Woods organized by his Institute for New Economic Thinking. “The markets are inherently unstable. There is no immediate collapse, nor no immediate solution."

If Soros doesn't know, then I suspect no-one does. However, I'm not running a giant hedge fund...

I have taken out insurance with some FTSE5300 put warrants. If the situation is "resolved" by the end of this week then I expect I'll sell them again (expecting to take a significant loss, but a price worth paying for a certain degree of comfort).

Regards,

Mark

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macroeconomix 19th Jul '11 11 of 118
1

Using options as a hedge during Armageddon with all the counter party risk associated with a house of cards collapse? ;)

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marben100 19th Jul '11 12 of 118

In reply to macroeconomix, post #11

I've already acknowledged counterparty risk in #5 above. Weighing the evidence, rather than complete "Armageddon" an unstable scenario involving a market panic seems a more plausible risk. In the event of complete "Armageddon" cash held in bank accounts wouldn't be safe either. My view is that the risk of not accessing your cash is similar to that of the counterparty risk.

The only completely safe thing in such a scenaro would be to convert all your cash to bullion, keep it somewhere accessible to you alone and buy a shotgun. Not really a world worth contemplating.

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macroeconomix 19th Jul '11 13 of 118
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The only completely safe thing in such a scenaro would be to convert all your cash to bullion, keep it somewhere accessible to you alone and buy a shotgun. Not really a world worth contemplating.


Quite - but with the anticipated fear of it, and your excellent rationale behind this statement ;) you can understand the reflexivity behind the current momentum in precious metals. And so I'd argue you might as well "hedge" by owning them. That's certainly what I've done anyway.

For me. O&G equities are the rump, gold/silver miners are a significant percentage, with the physical metals themselves as "hedge" for the worst case, and my secure steady fixed income and a little cash to provide optionality in case everything moves against me in the wrong direction.

I don't have a shotgun, can't imagine it ever ever coming to that TBH!

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Mattybuoy 19th Jul '11 14 of 118

I agree Zerohedge is very "slanted", but if you can get through the overly long and complex sentences and the innumerable acronyms there is information there in spades that anyone outside the markets just can't get anywhere else. I'm talking about a) the technicalities and b) how the big actors actually trade and think, including the Fed.

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snaj 19th Jul '11 15 of 118
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The Treasury has enough revenue coming through to meet the coupon payments (& other essentials such as social security, federal govt wages etc). There will only be a default if Geithner & Obama choose not to make the coupon payments - it is unthinkable that Obama is trying to hold the Republicans to ransom to agree a limit increase that he insists must be enough to get through next year's elections without a single firm spending cut, but plenty of tax increases. He has stated that he will veto any short term deal that would only be considered to aid the negotiations, the majority Senate Democrats have failed to produce a budget for nearly 3 years, whilst they rejected Obama's budget 97 to nil in April, the majority House Republicans produced a budget & passed it but the Senate and the White House are refusing to discuss it except to score political points by scaremongering.

Obama has played it well politically, but with huge costs for the US' economic standing now & in the future, although from his ultra-leftist perspective that's quite ok - just spreading the wealth to the lenders, whether they be Chinese, middle eastern, Russian etc.

So yes, I think the markets are being far too sanguine, particularly in respect of sovereign debt but that now applies not just to the Japanese and the Europeans, but also for the first time, US treasuries. On the other hand, Gary Shilling has written recently in Forbes about why he thinks we're still in a deflationary environment & I hesitate to argue with his analysis given a near perfect thirty year record. Maybe that's what is propping up the sovereign markets & the dollar?

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marben100 19th Jul '11 16 of 118

In reply to snaj, post #15

It is interesting how people with a different political viewpoint can reach precisely the opposite interpretation of the same events. Snaj:

...it is unthinkable that Obama is trying to hold the Republicans to ransom to agree a limit increase that he insists must be enough to get through next year's elections without a single firm spending cut, but plenty of tax increases. He has stated that he will veto any short term deal that would only be considered to aid the negotiations, the majority Senate Democrats have failed to produce a budget for nearly 3 years, whilst they rejected Obama's budget 97 to nil in April, the majority House Republicans produced a budget & passed it but the Senate and the White House are refusing to discuss it except to score political points by scaremongering.

 

Bob Kennedy:

As Krugman keeps pointing out, borrowing by the U.S. gov. is at historically low interest rates. Why? As some people have pointed out, one major reason is that the U.S. economy is actually awash with cash–held by banks, corporations, and wealthy citizens. The government’s “debt crisis” is a manufactured reverse Potemkin illusion created by ludicrously low tax rates on upper income levels–even without taking into account ludicrously high “defense” (sic) spending–and by elevated spending on recession-related decelerators like unemployment, food stamps, etc. There would be no immediate “debt crisis” at all If the political will was there: i.e., if the Republicans hadn’t turned into a fundamentalist sect that enforces strict adherence to dogma and promotes incredible political cynicism–nothing takes precedence over getting rid of Obama, even the national credit and welfare–and if Obama weren’t the President most interested in being “mature” by being “non-partisan” since John Adams, who was, it should be noted, a one-termer.

 

You pays your money and takes your pick, I guess. :0)

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emptyend 19th Jul '11 17 of 118
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In reply to snaj, post #15

The Treasury has enough revenue coming through to meet the coupon payments (& other essentials such as social security, federal govt wages etc). There will only be a default if Geithner & Obama choose not to make the coupon payments

....mmmm.....but what would happen about rollovers?   There would be regular rollovers needed of Tbills, Tnotes and Tbonds on likely a weekly basis.......what terms would rollovers be possible on if they haven't raised the ceiling and have been downgraded?

I forgot to mention earlier the issue of counterparty risk in circumstances of financial system disruption.....which is most definitely NOT to be underestimated or ignored, as it would destroy the liquidity (and therefore usefulness) of virtually all hedge instruments.

ee

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snaj 20th Jul '11 18 of 118
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ee, I would have thought that rollovers being on a like-for-like nominal amount of principal would remain within the debt limit, and assuming the coupons are paid why would there be a default? The problem boils down to Democrats having no intention of cutting spending & attempting to further expand the size of the state even after the GM nationalisation, Obamacare etc and essentially rendering the debt 'limit' to be a fiction when they control the White House. If they hadn't lost the House last November, the American future would be looking distinctly Greek right now rather than merely Spanish.

Mark, Krugman has been discredited as an objective economist a long time ago. He is sadly simply a mouthpiece now for the Democrats, but yes this is undoubtedly a political theatre rather than an economic event & I'm not in any way neutral. This President's leftist ambitions know no bounds and he is an extremely smart political operator, whilst the congressional Republicans have seemingly blown another opportunity to hold him in check & explain to the public why he should be a one-term President.

Sometime in Q2 next year, if it looks like Obama will win re-election, I would seriously consider the non-UK western world 'Armageddon' scenario for my investments & move predominantly to a mix of cash, I-LGs, gold, O&G, agriculture, UK property, UK & emerging market equities (if I can find them) that are focussed on their domestic markets without significant dependence on any of American, European or Japanese growth. Unfortunately I'm almost there a year early!

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