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 borrow- ing 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 solu- tion 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 specu- lative, 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 © Western Asset Management Company 2013. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission. Western Asset 1 October 2013 POLICY MATTERS Treasury Financing Status and the Debt Limit 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 de- fault 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 securi- ties 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? Western Asset 2 October 2013 POLICY MATTERS Treasury Financing Status and the Debt Limit a. How would Treasury proceed once it no longer had enough cash and revenue to meet its incoming obliga- tions? 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 re- gime, 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 pay- ments 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 pay- ments ahead of others. The Inspector General report cites both the complexity and questionable legal author- ity 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 op- tions, 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.