Currently Barack Obama is doing his utmost to avert a financial disaster. The US has a debt limit of $14.3 trillion dollars. This has already been surpassed (see US debt clock below) and is being financed by short term emergency arrangement with the Fed which involved holding back aids to states and borrowing from Federal pensions. By 2nd August if the US has not raised their debt ceiling, they will default.
Current US Debt as of 12.01 17/07/2011
At the moment the Republicans, who control the House of Representatives will not agree to a debt ceiling increase without planning significant spending cuts. Presumably at some point a compromise will have to be met and the US debt clock can continue ticking. But what if they didn’t agree, what if the unthinkable happened, the US defaulted -time for some ‘back of the envelope’ calculations and a hypothetical scenario.
Firstly the impact of default all depends on the type of default. For this calculation there needs to be some broad sweeping assumptions.
THE DEFAULT: If the US defaults on the interest payments only and not on the principal this will change the $14.3 trillion to a mere $502bn loss, assuming a 3.5% interest on the debt.
THE IMPACT: Many countries have large holdings of US debt, China would take a hit of $38bn and Japan $31bn. In the UK most of the holders of US debt are pension funds and private banks; they would be hit with an initial collective $11.5bn hit (£7bn). Note that this initial impact only hits the P&L. This would hit the profits of these companies but would not necessarily kill them. The problem is when the value of the bonds falls.
Assuming that the risk reward appetite has not changed (which it certainly would), the value of the bonds would continue to fall until the expected return of the asset equalled 3.5%. For example bond with a face value of $100 will fall to $96.62 This would mean an additional £7bn write down of assets.
THE CONCEQUENCES: The problem with an asset write down, is that if it leaves a company with more liabilities than assets, no one would lend to it. The reason being is that if the bank was liquidated, the lender would not be able to get all their money back. If a bank were to have this problem, no bank would lend to it and all its creditors would try to regain their money. In other words, there would be a Run on the bank.
The Banking sector has a further Macro issue. When a bank looses money, it is not able to lend it out. Normally a bank will lend out many times what it has in cash reserves, this known as Fractional Reserve Banking. In this instance the£7bn hit to assets turns into around a £70bn loss of available credit, which would otherwise have gone to businesses, mortgages etc.
There is also something far greater to worry about…systemic risk. All banks have lent money to many other banks. In the case above where a bank fails, all the other banks that have lent to it are also hit. They in turn will have to make asset write downs, perhaps not as big as the US default write down but if it is the tipping point for one bank then the rest of the industry will have to make another write down, and this process could potentially continue through several banks. This was the precise fear that stuck the banking industry when Lehman Brothers went down in Sep 2008.
Since 2008, banks have been increasing their reserves and improving their balance sheets so that risk of such an event would not happen again. But would it be enough? Recent stress tests showed that European banks would require another 80bn Euro to protect themselves form a Greek default, a US default would require significantly more.
A US default like the one described above would be unlikely to herald the end of capitalism as we know it, but it could prove to be the tipping point for several companies, banks and, possibly nations.
Thoughts, comments and questions welcome.
