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.
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