The Big Lie About a Possible US Debt Default

One of the blessing/curse things about how our office is laid out is the big, flat screen TV that hangs over the trading pit.  It provides breaking news, quick explanations for major market swings, and humorous GEICO insurance ads.  But lately, it’s been nerbling endlessly about the debt ceiling “debate” and the fact that this would be the first time since Andrew Jackson that the US Government had defaulted on its debt.

That particular lie is bothersome for two reasons:  1) it reveals that the media lacks any knowledge of American history, and 2) it implies that we have no historical precedent to which we could refer in the event the US had a brief default.

Stepping back in time to 1979, there was a progressive in the White House and the 96th Congress was in session.  During this go-around,   the argument was about raising the debt limit to a now-measly $830 billion.  In the final hours, a compromise deal was struck, but not in time to avoid problems in the coming days.

The initial default affected T-Bills that were meant to mature on 4/26/79.  While the Treasury was able to make payment to its institutional bondholders, individual investors were forced to wait for payment.  The same sort of delay occurred on Bills maturing 5/3 and 5/10/79.

When all was said and done, all investors received their payment — albeit late.  After a number of lawsuits, the individual investors were actually paid additional interest for the time their bonds where in limbo.  Hopefully that addresses the Big Lie.

As for the ramifications of a brief default, I refer to a graph of changes in the T-Bill rate in the days leading up to and the days following the default.

The initial spike in rates occurred about 105 days before the default when Henry Kaufman (the Nouriel Roubini of the 1970’s) predicted a dramatic rise in rates.  This spike was actually higher than the spike that occurred at the time of the default (95 basis points versus 60 basis points).  The largest spike in rates occurred about 115 days after the default, when Paul Volker raised Fed Funds rates from 11% to 12% over the weekend of October 6.  The graph is courtesy of Zivney and Marcus and all the appropriate props are offered.

So, what can be gleaned from all of this?  First, short term defaults are not the one of the Four Horsemen of the Apocalypse.  They create short-term pain, some lost status on the world stage, then everybody goes back to remembering that the US is still the most secure paper on the planet.  As for the predictive ability of the 1979 saga vis’ a vis’ our current situation…  it’s awfully hard to draw a conclusion.  In 1979 overnight rates were 11%.  Today they are zero.  In both cases the economy was weak and we had “big government” chief executives.  And in 1979 entitlements did not have the system teetering on the brink.

Now seems like a good time to stay the course while keeping systemic hedge trades at the ready (he said without any intention of providing investment advice which would be a no-no).  If you’re opinion differs, send me a comment.  That’s always good for avoiding confirmation bias!