Wall Street's Game Plan for Potential US Debt Crisis

As the US government continues to negotiate to raise its $31.4 trillion debt limit, Wall Street banks and asset managers are prepared for the consequences of a debt default. The financial sector has encountered similar challenges in the past, most recently in September 2021. However, the present short time constraint to establish a consensus has exacerbated worry among banking experts.

Citigroup CEO Jane Fraser said that the current debt limit issue is “more worrying” than prior instances, while JPMorgan Chase & Co CEO Jamie Dimon stated that the firm is conducting weekly meetings to analyze the possible repercussions of default.

Because US government bonds play such an important role in the global financial system, the effects of a US default might be far-reaching and impossible to foresee. Experts anticipate significant volatility across various markets, including equity, debt, and others. Trading Treasury positions in the secondary market would be severely impaired.

Wall Street executives who have advised on Treasury's debt operations have warned of the rapid spread of Treasury market dysfunction to derivative, mortgage, and commodity markets. This could result in investors questioning the validity of Treasuries as collateral for securing trades and loans. Analysts suggest that financial institutions may ask counterparties to replace the bonds affected by missed payments.

Even a brief breach of the debt limit could lead to rising interest rates, plummeting equity prices, and covenant breaches in the loan documentation and leverage agreements. Short-term funding markets are also expected to freeze, according to Moody's Analytics.

To prepare for potential disruptions to the Treasury market and broader volatility, banks, brokers, and trading platforms are implementing various strategies. These include planning how Treasury security payments will be handled, anticipating reactions in critical funding markets, ensuring adequate technology, staffing capacity, and cash for high trading volumes, and assessing potential impacts on client contracts.

Major bond investors have emphasized the importance of maintaining high liquidity levels to withstand potential drastic asset price fluctuations and to avoid selling at inopportune times. Bond trading platform Tradeweb has reported ongoing discussions with clients, industry groups, and other market participants regarding contingency plans.

The Securities Industry and Financial Markets Association (SIFMA), a prominent industry group, has developed a playbook detailing how Treasury market stakeholders would communicate and respond in the event of missed Treasury payments. Several scenarios have been considered, with the most likely involving the Treasury buying time by announcing ahead of a payment that it would roll over maturing securities daily. In this scenario, the market would continue to function, but interest would likely not accrue for delayed payments.

In the most disruptive scenario, the Treasury would fail to pay both principal and coupon amounts and not extend maturities. This would result in unpaid bonds becoming untradeable and non-transferable on the Fedwire Securities Service, the platform used for holding, transferring, and settling Treasuries. Each scenario would likely cause significant operational issues and necessitate manual daily adjustments in trading and settlement processes.

Rob Toomey, SIFMA's managing director and associate general counsel for capital markets, noted that while navigating an unprecedented situation is challenging, the organization aims to develop plans with its members to help them through the disruption.

The Treasury Market Practices Organization (TMPG), a New York Federal Reserve-sponsored industry organization, has also developed a framework for trading unpaid Treasuries, which it will evaluate by the end of 2022. The New York Federal Reserve has refused to speak more on the situation.

During previous debt-ceiling standoffs in 2011 and 2013, Federal Reserve employees and policymakers devised a script that would almost certainly serve as a starting point for current conversations, with the last and most delicate stage being the withdrawal of defaulted assets from the market.

The owner of the Fixed Income Clearing Corporation (FICC), the Depository Trust & Clearing Corporation, is keeping a careful eye on the situation and has modeled potential scenarios based on the SIFMA playbook.

The firm said in a statement, “We are also working with our industry partners, regulators, and participants to ensure activities are coordinated.”

As the debt limit battle rages on, Wall Street is on high alert, bracing for a number of possible scenarios. With the whole world watching, U.S. politicians are under increasing pressure to address the debt limit problem and avoid a possibly disastrous default. The financial sector is keenly monitoring the situation, preparing to handle the possible financial volatility brought on by a US debt default.

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