Treasury Financing Status and the Debt Limit

Policy Matters Treasury Financing Status and the Debt Limit

October 10, 2013

Treasury Secretary Jack Lew has said that unless Congress increases the debt limit, Treasury will run out of borrowing authority on October 17. As this deadline draws closer, we have received a number of questions from clients about the potential consequences if Treasury runs out of borrowing authority. It is important to emphasize at the outset that a default on Treasury securities is an extremely unlikely outcome. We are optimistic that a political solution will be reached before Treasury runs out of cash. The situation is extremely fluid: even as we write, there are new proposals being discussed that could push out the date that Treasury exhausts its borrowing authority past October 17. While we remain optimistic and are watching the back-and-forth in Washington DC very carefully, we do recognize the importance of thinking through all of the contingencies. The notes here outline our understand- ing of the options Treasury would face after running out of borrowing authority, as well as a discussion of how different parts of the financial system might be affected.

It is also important to note that any analysis of what will happen after the debt limit is reached is necessarily speculative, because there is no good precedent for the current situation, and because decisions made by individual policymakers are impossible to fully anticipate.

The following addresses three separate, but related questions: (1) What happens after October 17? (2) If the debt limit is not raised, can Treasury avoid a technical default? (3) How might the financial system respond to a technical default?

1. What happens after October 17? Unless a political solution is reached in the next few days, on October 17 the Department of Treasury will exhaust all of its borrowing authority and will have an estimated $30 billion in cash. Together with incoming tax receipts, the $30 billion in cash may allow Treasury to meet its obligations for a few days after the 17th.

The amount of time for which Treasury is able to meet its obligations will be a function of both incoming revenue and incoming obligations. There can be substantial day-to-day variation in both revenue and obligations, even across dates that don’t have large payments for Social Security, Medicare or debt interest. For example, last October payments on non-Social Security, non-Medicare and non-debt interest days varied from $3 billion to as much as $11 billion, with no predictable pattern to explain the changes. Moreover, the government shutdown has disrupted the normal patterns of revenues and obligations, making the flows over the coming weeks even more unpredict- able and thereby increasing the uncertainty about how long Treasury could go before not having enough cash on hand to meet a day of obligations. In recent analysis, the Bipartisan Policy Center estimated that Treasury might not have enough cash to meet its obligations as early as October 22, only five days after the 17th.1

Even if Treasury is able to successfully manage the day-to-day variation past October 22, it almost certainly won’t be able to meet all of its obligations on November 1. On November 1 Treasury will have approximately $70 billion of

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incoming obligations, due principally to large Social Security and Medicare payments on that day. It is very unlikely that Treasury will have enough cash or revenue to meet those payments. That Treasury will eventually run out of capacity to meet its obligations with incoming revenue should not be surprising: the US government has an annual budget deficit of around $700 billion and by definition this means that Treasury needs to continuously borrow in order to meet all of its obligations.

As detailed in the next section, there has been some discussion about whether Treasury could prioritize payments on Treasury securities in order to avoid a technical default. The table below shows the upcoming payment dates scheduled for Treasury securities. It is important to distinguish between maturing securities and interest payments. Treasury will theoretically be able to roll maturing securities without violating the debt ceiling. In contrast, making an interest payment requires additional cash or revenue, and therefore may be impossible without violating the debt ceiling. There are two interest payments highlighted in the table below—a $6 billion payment on October 31 and a $30 billion payment on November 15.

Date Type Amount (billion) 10/15/2013 Maturing Note/Bond $32 10/17/2013 Maturing Bills $120 10/24/2013 Maturing Bills $93 10/31/2013 Maturing Bills $89 10/31/2013 Maturing Note/Bond $61 10/31/2013 Interest on Note/Bond $6 11/7/2013 Maturing Bills $84 11/14/2013 Maturing Bills $79 11/15/2013 Maturing Bonds $63 11/15/2013 Interest on Note/Bond $30 Source: Bloomberg, Congressional Budget Office

Should Treasury make it past October 31, there would be another two weeks until the next interest payment were due on November 15. However, as noted, during the first two weeks of November Treasury would be unable to meet other payments, such as payments for Social Security and Medicare, and as a consequence would be in default on at least some of its obligations. Assuming that Treasury is able to roll its maturing securities—which is an important assumption and should not be taken for granted, given the heightened risk to auctions during a period of extreme uncertainty—this means that Treasury may be able to avoid defaulting on payments for Treasury securities through at least mid-November.

2. If the debt limit is not raised, can Treasury avoid a technical default? A lot of attention has been paid as to whether or not Treasury has any additional tools that can be employed to avoid defaulting on Treasury securities. This morning Secretary Lew testified in front of the Senate Finance com- mittee and received a number of questions on this subject. Broadly speaking, the discussion can be separated into two separate parts: (a) how would Treasury proceed once it no longer had enough cash and revenue to meet its incoming obligations? and (b) are there any other “emergency” options that Treasury could employ?

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a. How would Treasury proceed once it no longer had enough cash and revenue to meet its incoming obligations? Treasury has not been very specific about how it would proceed if Congress fails to raise the debt limit; instead Secretary Lew and others have insisted that there are no good options and failing to raise the debt limit is unacceptable. While today’s testimony provided a few more details, the best information on Treasury’s contin- gency plans may come from what Treasury was planning in 2011, which has been reported on by the Treasury Inspector General in an August 2012 report.2

In 2011 Treasury came to the view that the “least harmful option” was to implement a delayed payment regime, also known as “first in, first out.” Under this regime, each day’s payments would be delayed until there was enough cash to meet the entirety of that day’s payments. For example, under this regime all of the payments due on November 1 would be delayed until there was enough revenue to make the payments in whole, which could be as late as November 13 or November 14. This would mean that Social Security payments could be delayed up to two weeks, along with payments to hospitals for Medicare, civilian retirement benefits, etc.

As reported by the Treasury Inspector General, in 2011 Treasury also discussed the idea of prioritizing some payments ahead of others. The Inspector General report cites both the complexity and questionable legal authority to prioritize as reasons why Treasury did not view this as a good option. As has been reported elsewhere, because debt payments are processed through a separate system, Treasury may be able to separate interest and principal payments from other non-debt related payments, which may make it feasible to prioritize debt payments ahead of other payments. While the Inspector General report is silent on whether Treasury planned to prioritize debt payments in 2011, it was almost certainly discussed then and is likely being discussed again. Ultimately the decision as to whether or not to attempt a prioritization of payments on Treasury securities will be left to the judgment of the Treasury Secretary and the President.

b. Are there any other “emergency” options that Treasury could employ? While a complete catalogue of the ideas for “emergency” options is outside the scope of this note, below is a discussion of three ideas that are slightly more plausible than the rest. However, even within these three options, there is no clear path for Treasury to avoid the reality that the incoming revenues will be insufficient to cover all incoming obligations. While it is perhaps possible that an “emergency” option could be used to meet a debt interest payment, such action would at best create more uncertainty and would at worst create broader political and logistical challenges.

Freddie Mac Remittances: Under the revised preferred stock purchase agreement between Fannie Mae, Freddie Mac and Treasury, Fannie Mae and Freddie Mac are required to remit all positive profits back to Trea- sury on a quarterly basis. In 1Q13 Fannie Mae released a deferred tax asset (DTA) equal to $50.6 billion, which was then remitted to Treasury because it was accounted for as profit. In contrast to Fannie Mae, Freddie Mac has not released its DTA, which was equal to $28.6 billion as of their latest regulatory filing. In theory, Freddie Mac, in conjunction with their regulator, could choose to release the DTA, which would increase its quarterly dividend to Treasury and thereby provide Treasury with an additional $28.6 billion in cash. There are two big drawbacks for Treasury in pursing this option. First, the payments due on November 1 are around $70 billion, and Freddie Mac’s DTA would cover less than half of what’s due. Second, it is unlikely that the cash could reach Treasury immediately. The process would need to go through the regulator and the normal filings and it could take weeks for the cash to reach Treasury.

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The 14th Amendment: Section 4 of the 14th Amendment to the US Constitutions says: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” While some commentators have argued this gives the President authority to breach the debt limit in order to meet US obligations, it appears that the White House and Treasury do not agree with this legal analysis. Recently Mark Patterson, the former chief of staff for Treasury Secretary Tim Geithner, wrote “Although the scope of this language is unclear, constitutional authorities, including Professor Laurence H. Tribe and the administration’s own lawyers, do not believe it can be read to allow the President to continue borrowing above the debt limit to fund the ongo- ing activities of government”3,4 (emphasis added). Recently President Barack Obama has reiterated the point, saying, “So there are no magic bullets here.”5 Ultimately, it is the White House’s legal analysis, not the analysis of outside commentators, which will guide the President’s decision. In addition, as has been pointed out by Treasury and the White House, it is unlikely that invoking the 14th Amendment would provide a permanent solution, as the resulting legal battle would likely be protracted and acrimonious. During the period of legal uncertainty, the US might struggle to issue debt in normal auctions.

Debt Issuance Suspension Period: The Treasury Department has determined that a “Debt Issuance Suspen- sion Period” (DISP) exists through October 17. A DISP is defined as a period during which Treasury anticipates it will not be able to issue debt in a normal manner. If Treasury were to determine that it would not be able to issue debt in a normal manner for a much longer period, then it would have authority to immediately redeem certain securities from the Civil Service Retirement and Disability Fund. Specifically, if Treasury were to anticipate that the DISP would extend through next fall, they would have immediate access to about $75 billion in cash, which could be used to meet some incoming obligations.6 In late 1995 Treasury Secretary Robert Rubin anticipated that a DISP would last through the following year, providing a relevant precedent for Treasury to make such a determination.7 Importantly, any relief provided by declaring a longer DISP would be temporary, perhaps only long enough to meet a day or two of additional obligations. There is no lasting solution avail- able from declaring a longer DISP. Moreover, there would be significant political risks for President Obama and Secretary Lew. The administration has been adamant that there are no more options, and declaring a new tool at the last minute may lead to more uncertainty and a broader loss of confidence.

In conclusion, if the debt limit has not been raised by the time that the Treasury’s cash is exhausted, there are a few options that Treasury could potentially pursue in order to avoid default on Treasury securities. These include attempting to prioritize debt interest and principal payments, and perhaps one of the “emergency” options. None of these are straightforward or without significant risks, either for Treasury or for financial markets more broadly. Finally, whether or not Treasury will pursue these options is unknown and depends on both the judgment of the President and the Treasury Secretary and on the broader economic and market context at the time.

3. How might the financial system respond to a technical default? This final section touches on some of the potential consequences should Treasury miss either an interest or principal payment on a Treasury security. Two important caveats are required: (1) we think this an extremely unlikely scenario and we anticipate that a political solution will eventually be found to raise the debt limit, and (2) this is a fluid situation that requires constant monitoring, as the full consequences of such an event cannot be entirely anticipated ahead of time.

The uncertainty around the impacts of a technical default would likely cause the prices of risk assets to fall. Fol- lowing the downgrade of the US rating in August of 2011, US equity prices fell by about 17%. At the same time, consumer and business confidence fell, corporate bond spreads widened, and volatility increased. It is plausible

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that the magnitude of a market reaction to a technical default could be equal to or even larger than the reaction in August of 2011.

The reaction in risk markets could be exacerbated by the severe economic impact of Treasury having to miss or delay other payments. If the debt ceiling is not raised, Treasury would be required to at least delay some subset of its liabilities, possibly including Social Security payments, payments to veterans, or payments to government con- tractors. The resulting contraction of government spending (which constitutes income for many households and businesses) would take demand out of the economy and immediately lead to much slower US economic growth, potentially even causing the US to enter a recession.

Even as risk assets prices would be challenged, it is likely that US Treasury securities would remain one of the most liquid and creditworthy assets in the world. Again the experience in 2011 provides one point of reference. Around the time the US credit rating was downgraded, there was a significant flight-to-quality response in financial -mar kets and investors sought to hold Treasury securities because of the liquidity and underlying creditworthiness. Note that the US downgrade was just one of a series of market-moving events that contributed to the flight to quality. While it is impossible to separate the impact of the downgrade from everything else that was going on at the time—including turmoil in Europe, slowing global growth, and an anticipation of additional monetary easing— there is no question that as investor demand increased, the yields on Treasury securities fell significantly, reaching multi-decade lows in the months following the downgrade.

Whether Treasury securities would respond in a similar manner to a technical default is obviously uncertain. How- ever, it is probable that investors’ perceptions of the liquidity and creditworthiness of US Treasuries would remain intact. Importantly, if Treasury were to enter into technical default, the missed payment would very likely be made in full eventually, possibly after a delay of only a day or two. In this sense, a technical default would likely be a temporary occurrence. It is unlikely that Treasury would be viewed as insolvent, either by market participants or by credit rating agencies. It is even more unlikely that there would be a restructuring of Treasury securities that would involve investors recognizing losses.

There is no precedent for a high-profile technical default on Treasury securities, therefore any observations about the impact on different parts of financial markets is necessarily speculative. While the risks are clearly to the down- side, note that many financial market participants retain some degree of flexibility with regards to their guidelines and investment restrictions, which could help prevent a technical default from causing a broader market disruption. For example, money market mutual funds would not be required to immediately sell Treasury securities that had defaulted. Instead, the 2a-7 rule provides a period of time for the funds’ board to determine the best course of action, and in many cases the board will have the ability to simply hold the securities until Treasury is able to pay in full. Such flexibility is very important, as it will help prevent forced selling into distressed markets.

Another example of how flexibility may help support the financial system in the case of a technical default can be found in the repo market. While a Treasury security currently in default would likely be unacceptable as collateral in a repo arrangement, repo participants may have the capacity to distinguish between impacted and non-impacted securities and simply present non-impacted securities as collateral instead. There is already some evidence of market participants being able to distinguish between securities in this manner. In addition, the Federal Reserve (Fed) may decide to accept defaulted securities as collateral for discount window lending or to purchase outright. In either case, support from the Fed could help maintain liquidity in the repo market.

While this flexibility would help at the margin, there would likely still be significant disruptions in markets, especially in markets for impacted Treasury securities. One path through which concerns in Treasury markets could translate

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into a broader financial market disruption is through short-term funding markets. Uncertainty about the status of Treasury securities could cause rates on repo to rise and may cause some participants to temporarily exit the repo market. These market participants may choose to keep their funds in bank deposits or other cash-like instruments. A sustained increase in repo rates could cause stress on financial institutions that are dependent on the repo market for overnight funding, and in this case could be especially negative for non-bank financial institutions that would not benefit from any deposit inflows.

On a longer-term basis, it is possible that a technical default may affect investors’ perceptions of the US political system. Heightened risks from US political dysfunction could, over time, result in a weaker US dollar and a higher yield on US Treasury securities. Importantly, the extent of any lasting impacts on the dollar or US Treasuries would depend on how the impasse was resolved and the forward outlook for US politics.

Finally, it’s important to acknowledge the possibility of unanticipated adverse impacts on financial markets. As has been the case in almost all periods of past market stress, it is likely that vulnerable parts of the market are not clearly identified until they are already in difficulty (examples include Long Term Capital Management in 1998 and MF Global more recently). The uncertainty resulting from a technical default has the potential to be broadly desta- bilizing for financial markets.

Sources: 1 Bipartisan Policy Center, “As BPC’s X-Date Window Narrows, Economic Risks Grow” October 8, 2013 http://bipartisanpolicy.org/blog/2013/10/08/bpc%E2%80%99s-x-date-window-narrows-economic-risks-grow

2 Inspector General of the Department of the Treasury, Letter to Senator Hatch, August 24, 2012 http://www.treasury.gov/about/organizational-structure/ig/Audit%20Reports%20and%20Testimonies/Debt%20Limit%20Response%20(Fi- nal%20with%20Signature).pdf

3 Mark Patterson, “One way out on the debt ceiling,” Politico, October 3, 2013: http://www.politico.com/story/2013/10/one-way-out-on-the-debt-ceiling-97792.html

4 Laurence Tribe, “A Ceiling We Can’t Wish Away,” New York Times, July 7, 2011: http://www.nytimes.com/2011/07/08/opinion/08tribe.html

5 Transcript of President Obama’s Press Conference, Washington Post, October 8, 2013 http://www.washingtonpost.com/politics/transcript- president-obamas-oct-8-news-conference-on-the-shutdown-and-debt-limit/2013/10/08/866088c0-3038-11e3-8906-3daa2bcde110_story.html

6 Secretary Lew letter to Speaker Boehner, May 17, 2013: http://www.treasury.gov/initiatives/Documents/Debt%20Limit%205-17-13%20Boehner.pdf

7 United States General Accounting Office, “Analysis of Actions During the 1995-1996 Crisis,” August 1996: http://www.gao.gov/assets/160/155577.pdf

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