Annie Lowrey presents a scenario in which a partial debt default would lead to a full-fledged financial crisis. The basic story is that some government bonds will be in default. Defaulted bonds cannot be used as collateral in the huge repo market where hundreds of billions of dollars of money and bonds are traded every day and is the basis for the country's systems of payments. Since there is no simple mechanism for marking defaulted bonds that distinguishes them from other bonds, there will be no way to ensure that collateral is valid, therefore the whole market will shut down and the system of payments will collapse.

This is an interesting scenario. On the other hand, it is interesting to look at the fundamentals here. The vast majority of bonds that might be used as collateral will not have defaulted. Even the ones that are technically in default will have only lost a small fraction of their value. Think it through. You have a government bond that was supposed to have a coupon payment on October 17th which was not made because of the debt ceiling standoff. How much less are you willing to sell this bond for on October 18th? (If you say 3 percent or more, send me a note.)

While this set of events could possibly undermine the system as it functions today, if the bankers could not develop a workaround pretty quickly, they are a lot dumber than people give them credit for. Remember, this situation is fundamentally different than what we saw in 2008. In 2008 there was trillions of dollars' worth of genuinely bad collateral tied to defaulting mortgages, which were in turn tied to houses that had lost much of their value. This was a case where the music stopped and the money really wasn't there. In the current situation, does anyone really doubt that at some point the government will make the interest and principle payments on its debt?

None of this is to dispute that Lowrey's scenario of a financial crisis may not be right. The Wall Street boys really don't seem to be very good with numbers. Put to the test, they may well fail.

Leave your comments

Post comment as a guest

0
  • No comments found

GuideStar Exchange Gold charity navigator LERA cfc IFPTE

contact us

1611 Connecticut Ave., NW
Suite 400
Washington, DC 20009
(202) 293-5380
info@cepr.net

let's talk about it

Follow us on Twitter Like us on Facebook Follow us on Tumbler Connect with us on Linkedin Watch us on YouTube Google+ feed cepr.net rss feed