The Debt-Ceiling-Debacle: The Surprising Way a Default or Downgrade Could Crush the Global Economy

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If there's a "worst-case scenario" for this whole debt-ceiling debacle, this is it.

After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge – and economies around the world would crash.

Tangible evidence that this frightening scenario could really play out surfaced on Monday, when the Chicago Mercantile Exchange (CME) announced it was increasing the "haircut" that it applies to U.S. government debt posted as collateral by traders transacting on the exchange.

The retail investors who didn't just ignore this announcement altogether probably dismissed it as a boring bit of administrative housekeeping by the CME. In truth, however, this kind of re-evaluation of U.S. Treasury securities, widely used as loan collateral, could trigger global margin calls and widespread asset sales. If that occurs, it's only a matter of time before the ripple effects of escalating margin calls could weigh down asset prices around the world.

Let's take a look at how and why this could happen.

The "Haircut" Nobody Wants

Because U.S. Treasury bills, notes, and bonds are considered "risk-free" they are every lender's preferred collateral class.

All of America's too-big-to-fail banks, major securities broker-dealers and giant hedge funds – and most of the world's biggest financial institutions – hold hundreds of billions of dollars of U.S. Treasuries that they use as collateral to borrow in the overnight and term "repo" market.

Traders use their U.S. Treasury securities to borrow more money to buy still more Treasuries, as well as other more-speculative securities. The intention is to leverage the capital they have by borrowing against balance-sheet assets to take on bigger positions.

But what happens if there's no debt-ceiling deal by Tuesday – the theoretical day after which the country won't be able to pay its bills?

The actual answer to that question may not matter as much as the uncertainty that's been created. In fact, even with a deal – meaning there's no default – it's likely the United States is facing a reduction in its top-tier AAA credit rating.

In the event of a U.S. default, a downgrade, or a combination of the two, the Frankenstein-like facelift that will change markets for years to come is going to start with a "haircut" that trims the collateral value of U.S. Treasury debt.

Lately, the word "haircut" has been transformed to mean a loss – as in "my stocks went down in the bear market … man, I took a real haircut."

But that's not the technical definition.

A "haircut" is actually a securities-industry term that pertains to the U.S. Securities and Exchange Commission (SEC) Uniform Net Capital Rule 15c3-1. Securities broker-dealers, regulated by the SEC, have to maintain a minimum amount of "net capital" – or enough of a capital cushion to remain solvent.

When calculating their net capital, securities firms weigh their liabilities against their assets.

But not all assets are treated equally.

In some cases, such factors as credit risk, market risk and even its maturity can bring about an increase in uncertainty for certain assets. If that happens, the SEC can demand that firms "haircut" that asset – marking down its cash value using general formulas that discounts its "present value."

The more an asset has to be haircut, the less its collateral value becomes.

The Collateral Calamity

Because U.S. Treasuries are U.S. government obligations and have traditionally been considered to be essentially risk-free, they typically haven't had to suffer much in the way of haircuts.

In fact, short-term Treasury bills aren't haircut and the longest-dated Treasury securities are only haircut by 6%. For the most part, haircuts on government securities are based on weekly yield volatility measures calculated by the Federal Reserve Bank of New York.

But since traders have used those Treasury securities to borrow more money to buy more government bonds and other (more-speculative) investments, a bigger-than-normal haircut on federal debt obligations will cause lenders to demand additional security on the loans they've made to leveraged trading desks around the world.

Leverage is all fine and good, as long as one of the following two things don't happen to you.

The first thing that's bad news for leveraged trader is if prices fall. If you're leveraged enough, and the prices of the assets you're loaded up with start to decline, you can quickly start eating into your capital base.

For example, if you are leveraged 10-to-1, meaning you have $1 of capital and a $10 asset position, the price of your position only has to fall by 10% to completely wipe out your capital. In the current market environment, a 10% move in just about any asset class can happen in a day or two – if not in a matter of hours or minutes.

The second thing that wreaks havoc with leveraged trades is if the collateral that's been posted to borrow money (with which the leverage is accomplished) falls in value, then lenders will demand additional collateral, usually in the form of cash.

Of course, the double whammy occurs if the value of your collateral (in our present scenario, that means U.S. Treasury securities) falls at the same time that the securities you're leveraged up with (we're once again referring to U.S. Treasuries) also fall in value … well, you're toast.

And the fallout won't end with you.

The Ultimate Debt-Ceiling Debacle

This could actually result in a kind of "global margin call" – kicking off a worldwide de-leveraging scenario that could sink global markets and torpedo world economies. That's the Frankenstein-like facelift I referred to earlier.

Here's why.

The credit-ratings downgrade and an outright default play a big role in this, too. You see, while a ratings downgrade would affect America's perceived credit quality, an actual default would change the market's fundamental consideration of cashflow rights and the degree of certainty held about future payments regarding government obligations. Such a radical change in the quality and market-risk features of government securities would mean that they would be subject to deeper haircuts.

There's the debt-ceiling-debacle "trigger" I've been talking about.

As leveraged institutions have to take deeper haircuts on the Treasuries they've put up as collateral for their loans, they'll have to come up with additional collateral. If at the same time they are required to post additional collateral their leveraged positions are being marked down, there's likely to be a sell-off of multiple asset classes as cash has to be raised.

Default is a game-changer.

Government securities will no longer be pure-interest-rate instruments. They will immediately assume the risk profile and characteristics of lesser-credit products and not be the baseline against which all other credits are measured, but demand new measures of their own default probabilities.

It's bad enough that the U.S. government securities market is the largest securities market in the world. What's even worse is that the derivatives market – which is at least 100 times as large as the U.S. government securities market – principally uses Treasury securities as collateral for their "private contracts."

If you don't think this is a real scenario, think again: Monday's move by the CME shows that it's already started.

It's only a matter of time before the effects of building margin calls weigh on asset classes around the globe.

To be forewarned is to be forearmed: Let's just hope that Washington resolves this whole debt-ceiling debacle before this global-margin-call cycle gets started.

[Editor's Note: If there's a lesson for us to learn from the past five years, it's this: A shrewd, fast-moving and greedy Wall Street is going to outfox an indentured, corrupted and gridlocked Washington ... every time.

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We bring it to you each day in Money Morning. We not only give you the news, we tell you what that news means and show you how to turn it to your investing advantage.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. barry klieger | July 29, 2011

    I have no comment . . .

  2. Angel | July 29, 2011

    Mr. Bush what do you think about your nine year ""not in a recession. We are in a slowdown?" Four out of five Americans support your compromise for the common good or pass the debt ceiing like they have always done! We support Senator Bernie Sander’s reasonable position to stand up for Middle Class Americans against these right extremist! Stop the hypocritical republicans from spreading their continued fairy tale lies that stopping the continued Bush tax cuts (give a ways) for billionaires and Millionaires will negative impact on the job creators! This B.S. has gone-on for 9 years with less Americans employed, but more American jobs being outsourced to China by many of these same billionaires and millionaires that do not pay their fair share. 75% of Americans are sick and disgusted with these political prostitutes that are taking thousands of $$$$ from Grover Norquest for their campaigns from the same billionaires and Millionaires! Are you listening, tea party obstructionists that are not interested in the future of middle class Americans? It’s all about jobs stupid! House Speaker John Boehner and House Majority Leader Eric Cantor, Mr, Ryan,Americans are asking where the job is creating legislation in the House of Representatives that you promised last election. Another year of no taxes for Grover Norquest, Russ Lindbaugh, Koche brothers and their Billionaires and Millionaires mislabeled “job creators," but still have no new jobs after nine years? So where's the Jobs?

  3. fallingman | July 29, 2011

    Yeah. Well said. This risk seems pretty obvious to me, along with the prohibition some institutional investors face against holding securities rated below AAA. They would have to divest themselves of Treasuries, would they not? Am I missing something?

    Why have I heard no one but Mr. G pointing out these problems?

  4. Joe Sullivan | July 29, 2011

    All right, so how do we hedge agsinst this outcome?

  5. Irene Paul | July 29, 2011

    Are I bonds save?????????//

  6. Richard Ahetrn | July 29, 2011

    Law of the Land-No one is bound to obey an unconstitutional law and no court are bound to enforce it

    Sixteenth Amrican Jurisprudence Second Edition, Section 256

    A Constitution in which government insures personal rights, by law. Elected representatives (experienced in government to reppresent us and protect our Constitution to preserve our personal liberties

    It is recessary that the American people understand, first, the intent of our Constitution and secondly, the principals of the free enterprise system or else there is no stopping the trend towards socialism and ultimate drastic changes in our government and economy. We would n o longer be a dynamic people.
    God
    People
    Government
    What has happned all four branches of government have taken a end around the US Constitution- This is called centralization of government and creeping socialism the very pitfalls our forefathers cautioned us to avoid.
    Richard Ahern_Vice President-Waste Watchers Inc

  7. Gloria Lane | July 29, 2011

    Is my little bit of money in my bank safe? If after August 2 2011 I go to my bank to close my account will the doors to bank be locked as they were back during 1930's depression, My grandfather lost $40,000. The USA government confiscated it. To me that is robbery by the USA government to an individual.

  8. livefree1200cc | July 29, 2011

    This article is pro-Big Bank. We don't need to raise the debt limit, we can't afford it. Any nation that still believes we have AAA credit rating is a little 'soft between the ears'. Everyone in every country knows the US economy is going DOWN, they have all of our jobs ! You can't prosper without jobs, and seeing as how the previous borrowing and spending didn't 'create' any, there is no reason to believe that more spending and debt will either.

  9. topeka | July 29, 2011

    Whatever… as my teenager would say. If you think I (small biz guy) can pay for this nonsense you are out of your mind: those treasuries are worthless at this moment. The markets will have to get used to the idea of responsible government willing to pay off the waste of 70 years of "social injustice" or accept wall-paper money.

    And let me add: I am sitting in a skyscraper in Dallas and as far as I can see there is no one in sight who even knows what the heck you are talking about *and* who has any expectation of what would happen when the golden-egg laying geezers like me give up or pop a gasket. (ok this is a comment – not great literature)

    Hope your parachute is packed…

  10. Enrique Alveo | July 29, 2011

    If USA credit rating is downgraded, what would happen with the USA dollar? Thanks for your comments.
    Regards.

  11. P. Grimes | August 5, 2011

    This morning I read this article and "The real reason for yesterday's stock market sell-off". I was impressed with Shah Gilani's insights and will add him to the list of financial analysts I feel are worth paying attention to.

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