Investors Ponder A New Frontier: Federal Default
FROM his computer terminal at Bankers Trust Companyhere, John Burgess is watching as House Speaker Newt Gingrich and President Clinton play a game of chicken.Skip to next paragraph
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The results of the game, over the national debt-imit ceiling, could potentially mean a lot to Mr. Burgess, a managing director, who formulates the strategy for $18 billion in clients' money invested in government securities. Burgess' strategy right now is to ''monitor closely'' the Washington moves.
The Washington schemes are complex. On Tuesday night, a House panel agreed to raise the debt limit so the government could get through to Dec. 13. Treasury Secretary Robert Rubin, however, believes the fine print is too restrictive and is recommending that Mr. Clinton veto the plan.
If the president does nix the proposal, the first test to see who blinks first could come as soon as Nov. 15, when the government is scheduled to make a $25 billion interest payment. If there is no debt extension, there may not be any interest payment. The Treasury is trying to conserve cash to get through the potential crisis.
The prospect of Uncle Sam defaulting - even if only for a short time - makes some Wall Streeters very nervous. ''As an American, it makes me angry as all get-out to see people playing with our credit rating for their own political purposes,'' says Robert Brusca, chief economist for Nikko Securities Company International Inc., a Wall Street brokerage house.
The US government has never defaulted on its debt, which is backed up by the ''full faith and credit'' of the United States. Should it default, however, ''It would be a long-term blot on the nation's credit worthiness,'' says William Sullivan, a senior vice president at Dean Witter Reynolds Inc.
Last year, Orange County, Calif., defaulted on its bonds after some ill-timed investments. As a result the county had to lay off workers and scale back its services.
''This is no different from Orange County,'' says Robert McKnew, chairman of the Public Securities Association (PSA) and a vice president of Bank of America in San Francisco.
Wall Street bond traders believe a default would certainly cost the government more money to fund its debt in the future because of fears of future defaults for other political purposes. ''Where does it end?'' asks Mr. McKnew who fears there could be a ''pattern of defaults.''
Although most bond analysts believe it is still too speculative to guess how much more it would cost the government to fund its debt after a default, Mr. Sullivan hypothesizes that a default could raise the government's borrowing costs by as much as 0.05 percent, or about $1 billion per year on the nation's $3.1 trillion in outstanding debt held outside the federal government. Another $1.8 trillion is held by the US government.
A small group of Wall Street bond traders disagrees. Last week, Stanley Druckenmiller, who works for billionaire George Soros, told a group of Republicans that it was worth a default to get a balanced budget. He predicted that long-term interest rates would fall to as low as 5 percent with the budget in the black. Long-term Treasury rates are currently about 6.31 percent.
And on Tuesday, the Financial Executives Institute in Washington released a poll of 580 corporate financial officers, two-thirds of whom endorsed the concept of linking the balanced budget to the debt ceiling.
Most bond-market participants agree that the ramifications of a US default are hard to guess at, since it has never happened before. McKnew, however, believes a default would ripple through the financial system since so many financial markets rely on US Treasury securities for collateral. For example, many large institutions and individuals buy securities on margin, or only a percentage of their value, by using government securities as collateral. ''Margin requires perfect credit,'' says McKnew. Thus, the futures markets could be adversely impacted.
Burgess is concerned over what a government default might mean for institutions with a fiduciary responsibility. For example, some of his asset managers run money-market funds that invest in securities rated AAA, the highest rating. What are the legal responsibilities of such funds if a default occurs? ''I don't know the answer to that question,'' he replies.
There will also be thousands of individuals counting on receiving the interest on their debt. With the interest, they pay bills and buy goods. If they don't get paid by the government, they may not be able to pay their bills.
''You could have lawsuits filed over this,'' says Mr. Brusca, adding ''People could be really inconvenienced.''