Here's How Wall Street Is Preparing for a U.S. Debt Default

If a natural disaster were to hit the city, there are plans in place to minimize damage, but some damage would still be inevitable.

Here's How Wall Street Is Preparing for a U.S. Debt Default

Last week, I spoke to two Wall Streeters who were planning their next steps in the event that Congress and the White House cannot reach an agreement on raising or suspending debt ceilings. The two people I spoke with said that the contingency plans for a federal default have never been tested, so it is not known how effective they would be. They said that even if the plan worked exactly as intended, it would still harm the economy.

Even the best case scenario is not good. Imagine Wall Street managed to minimize any damage caused by a short default. This could lead some politicians to believe that the warnings are exaggerated, and they may be more willing to take a risk on another default. Once broken, the power of a taboo is lost.

Beth Hammack is co-head of Goldman Sachs' Global Financing Group. She leads a committee governed by federal law called the Treasury Borrowing Advisory Committee. This group meets with Treasury Department every quarter to give advice on how the department raises money via the sale of bonds, bills and notes.

Hammack said that the U.S. Government not making a payment was a threat to financial markets. We're discussing a piece paper that is marketed as being risk-free, or almost risk-free.

I asked her if she felt confident in the contingency plans for a possible default developed by the Treasury Market Practices Group. (More on this later). She said, "It has never been tested." Nobody knows if this will work. It's a bad workaround.

She said that it is wrong to believe that there is no harm done if the government quickly makes up all of its payments and a short default occurs. She said that damage is already done. She cited the rise in interest rates for Treasury securities maturing around the time when the Treasury will run out of options to delay the debt ceiling.

Hammack stated that the U.S. has a unique position in the financial markets. People flock to our products during times of uncertainty, because they trust the U.S. Government. We are putting the dollar dominance of the U.S. at risk if we do not pay our debt.

Robert Toomey, a managing Director, associate general counsel, and head of SIFMA's capital markets practice, an influential trade association for the securities industry, gave me a similar message. He said, "We don't really know what's going to happen." "We have no precedent." You prepare to cause the least amount of disruption on the market.

SIFMA wrote a guide on what to do in the event of a disruption to Treasury payments. The playbook does not mention the debt ceiling, possibly to avoid appearing political, but instead mentions'systems problems, natural disasters, terrorist acts, or other reasons'. The schedule is in place for meetings if Treasury notifies them that a payment will be missed at a specific date. Two meetings are scheduled for the evenings before this date at 6:45 pm and 10:15 pm. Three of the next four occur on the scheduled day for payment, at 7:30 am, 11 am, and 2 pm.

The Treasury Market Practices Group sponsored by the Federal Reserve Bank of New York will also be a key player if there is a default. Hammack was a member of it. Hammack's organization is also made up of executives from the private sector. Its mission statement is to'support the integrity and efficient of the Treasury debt, agency mortgage-backed securities and agency agency debt markets'

Treasury Market Practices Group's seven-page contingency plans are coordinated with SIFMA and were last updated in December 2021. The plan states that implementing the practices described would only reduce the operational problems caused by late payments of Treasury debt modestly, but not completely.

The Fedwire Securities Service is used by buyers and sellers to transfer Treasury Securities. On weekdays, it's usually open until 7 pm Eastern time. The person who receives a Treasury Security's principal at maturity is the one that held it the previous day, as of 7 pm, when Fedwire Securities Service was closed. At that point, the security is frozen and nontransferable. This rule is strict to avoid confusion about who has the right to receive payment.

In the event of default, a rule that is effective in normal times could be disastrous. Each Treasury would be frozen and unable to be used for loans or sold. Treasury securities are what makes Wall Street work, so freezing them as they mature would cause a disruption in the way high finance operates. This would quickly spill over into the real economy.

Treasury Market Practices Group suggests that Treasury inform the Fed a minimum of one day in advance if it is not going to make the scheduled payments. Fedwire Securities Service could then change its usual practice to extend the "operational" maturity date by a day. This would allow the holder to have an extra day to either sell or borrow the security. The stopgap would only last one day but the group's contingency plan states that 'this practice could be repeated every day until the principal is paid'.

There's still a lot to be done. Treasury Market Practices Group: "Some participants may not be able implement these practices and others might only be able do so with significant manual intervention in their settlement and trading processes. This would itself pose a significant operational risk." There would be other operational problems that are likely to arise. These could be serious and not currently foreseen.

There is, in short, a Plan B. Plan A, which is raising the debt limit, is 1000 times better.

Preston Mui

In a report published on Friday, Preston Mui, senior economist for Employ America, an organization that advocates full employment and supports research, said that the U.S. labour market is softening. However, there are few signs that unemployment will increase significantly this year. He wrote that one sign of continued strength is the fact that the Black unemployment rates in April were only 1.6 percentage points above the white unemployment rates. This is the lowest rate in Bureau of Labor Statistics' records dating back to 1972. When demand for labor is high, the gap tends towards narrowing. Mui wrote that the Fed's projections of 4.5 percent unemployment at the end this year seem implausible. To get there, the unemployment rate would have to increase very quickly.

Quote of the day

"To sell or buy something for more than it is worth, in and of itself, is unjust.

St. Thomas Aquinas' Summa Theologica: 'Of cheating which is committed in buying and selling,' Objection 3, 1265-1274