The consensus that politicians would never actually permit US treasuries to default has so far maintained relatively orderly financial markets. But as the federal government shutdown persists and House Speaker John Boehner vows there will be no vote on raising the debt limit without concessions from Democrats, corporate treasurers may want to consider their limited options.
Those concerns are certainly harbored by participants in the credit default swap (CDS) market, where the price for protection reached as low as 22 basis points on September 9, and as of October 4 had nearly doubled to 42 basis points, according to Amol Dhargalkar, head of Chatham Financial’s risk-management team servicing corporates.
He added that CDS can hedge against the entire sovereign, so any default in the sovereign’s debt would trigger a payout. However, if the US government defaults, Mr. Dhargalkar said, there’s a very real question about whether bank counterparties will have sufficient liquidity to pay out. Banks are major investors in Treasuries, and other markets likely to be negatively impacted—equities, commodities, currencies, etc.—typically make up a large portion of a bank’s book.
“Anybody considering this path should ask these questions,” Mr. Dhargalkar said.
The US Treasury Department estimates it will run out of funds as soon as October 17. RBC Capital Markets estimated in a recent report that the government agency would likely have cash until the end of the month, and described the catastrophic consequences of a Treasury default on financial markets such as repos (see related story: Risk Management: Collateral Consequences of a Treasury Default)
Mr. Dhargalkar said Chatham has received some inquiries about how to hedge that risk, but the financial risk-focused advisory firm had already discussed the issue at length with most of its clients in the run up to previous years’ debt-limit brouhahas. In addition, few of the firm’s clients – Mr. Dhargalkar estimates around 1 percent – post liquid securities or cash as collateral for swaps or other structured transactions, as many trade without posting any cash collateral.
For those that do, one option may be to convert those bonds into cash. Mr. Dhargalkar said most swaps agreements contain mechanisms allowing for such conversions, but firms posting the collateral should delve into the documents to confirm that’s the case. “Most counterparties would likely be happy to take cash over government securities,” Mr. Dhargalkar said.
The bigger impact of a Treasury default on corporates may simply be on their investment holdings. Most corporates tend to invest in Treasuries, so shifting into cash may be the safest option. To maintain some return, “move it into the next safest haven, which is probably some combination of [bonds denominated in] euros, sterling, Swiss franc and yen,” Mr. Dhargalkar said, adding, “As the old Wall Street adage goes, ‘the best hedge is a sale.’”