JPMorgan’s US debt default Q&A

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When will Treasury exhaust all measures to avoid a technical default?

The debt ceiling has been at the forefront of our discussions with clients since Treasury declared a Debt Issuance Suspension Period in mid-January, but these conversations have increased with frequency and attention since the anticipated “x-date” for a technical default has been brought forward. Secretary Yellen wrote to Congressional leaders earlier this month, saying Treasury “will be unable to continue to satisfy all of the government’s obligations by early June, and potentially as early as June 1.” Indeed, with the data we have in hand from Treasury, $88bn in extraordinary measures remained as of May 10. As a result, we now forecast Treasury will exhaust all available resources to continue to avoid a technical default by June 7. Importantly, with approximately $80bn in Social Security and Medicare payments due in the first two days of June, Treasury will be running with little margin for error after June 2. To be clear, the tone out of Congressional leaders has improved in recent days, indicating lower risks of a technical default, but the timeline to reach an agreement remains tight.

How are markets likely to react in the days following a technical default?

This is certainly not our modal view, but in the unlikely event of a technical default, we think Treasury yields would decline and the curve would steepen. This seems unusual in the context of a default, but Treasuries have rallied into the latter stages of other serious debt ceiling debates in 2011 and 2013. Moreover, though a downgrade would likely have ratings implications, Treasuries remain the highest rated asset in the US and given rising policy and economic uncertainty, would likely rally as risk aversion increases. Interestingly, our clients share a similar perspective on this. Between May 9-11 we conducted a survey on the anticipated change in rates, credit spreads, and currencies in the unlikely event of a technical default. We received responses from 123 institutional investors. 61% of respondents expect 2-year yields to fall by an average of 18bp, while 67% of respondents expect 10-year yields to fall by an average of 22bp. Implicitly, this would leave the 2s/10s curve modestly flatter. Meanwhile, there is no strong consensus on how front-end swap spreads would perform: 55% of respondents expect some widening, by an average of 2bp. Finally, there’s a consensus that SOFR-RRP spreads would widen only modestly: 91% of respondents see this spread widening by an average of 6bp.

What is the impact on Treasury auctions from the risk of a potential technical default?

In the 2015 debt ceiling episode, Treasury announced a delay to the 2-year note auction originally scheduled for October 27, citing concerns that it would be unable to settle the notes — the first time this had occurred since May 2003. With Treasury estimating it will exhaust all resources on June 1, we think the 4-week and 8-week bills slated for auction on June 1 are at risk for postponement, as are the 13-week and 26-week bills to be auctioned on June 5.

What Treasury securities are likely to be most impacted by technical default concerns?

Thus far, it’s only been T-bills that mature in the potential default window that have underperformed, trading 20-30bp cheap to T-bills maturing in July. We note that there are no cross-default provisions on Treasuries, so this is why dislocations have been somewhat localized. There are also likely to be selective dislocations in the repo markets, as haircuts applied to various bonds will likely differ, with bonds with mid-June or mid-December maturities incurring larger haircuts.

One question that has often come up is about the cheapest-to-deliver (CTD) bond into the US sovereign CDS contract. The 1.25% May-2050s are the lowest dollar priced bond in the Treasury market, trading with a $55 price, as these bonds were auctioned in mid-2020 when the Fed funds rate was floored at the ZLB and long term rates were 250bp lower than they are now. However, the impact of the CDS market on the cash market is likely to be minimal: the May-2050s have a $74bn float and the Fed owns $19bn, while DTCC data shows that there was just $5.7bn of net notional outstanding in US sovereign CDS as of last week.

If we get to the point where Treasury exhausts headroom under the debt ceiling, will it still be able to roll over maturing securities?

Treasury can roll over maturing coupon securities on the maturity date without affecting its outstanding debt or remaining cash balance as long as it makes the coupon payment due on the same day. The mechanics are slightly more involved in case of Treasury bills. T-bills are issued at a discount to par and hence proceeds from bill auctions are, assuming positive yields, lower than the amount due at maturity. According to Treasury’s accounting rules, the unamortized portion of this discount amount is not subject to the debt limit. With every passing day, the amortized portion of the discount gets counted toward the debt ceiling, though this amount is very small compared to Treasury’s average daily cash flows. Thus, rolling over bills would actually create borrowing headroom equal to the discount amount, albeit tiny, while reducing the cash balance by the same amount.

If Treasury does miss a payment, is the security still transferable?

Treasury can, in principle, delay coupon or principal payment dates. If Treasury announces its intention to postpone a payment date in advance (the day before the payment is due), the security will remain in Fedwire, and would therefore still be transferable. The Uniform Offering Circular does not address delayed/missed payments. If Treasury were to delay its payment obligations, we expect it would extend the payment date by one day at a time. For example, if Treasury anticipates it would not be able to make a payment that is due on a Tuesday, it can send a notice on Monday stating that it would extend the payment due date by one day to the following Wednesday. This process can be continued until Treasury has enough cash to make the payment.

When does a Treasury security drop out of the system? What will happen to the defaulted security?

According to the latest SIFMA guidance released earlier this month, if Treasury fails to notify investors of its intent to delay a principal payment due the following day by approximately 10:00 PM, the security in question will drop out of Fedwire, and such defaulted security will not be transferable. If (only) a coupon payment is missed, however, the underlying security is still in the system and remains transferable. In both cases, the holder on record as of the date of the original failure to pay will hold a receivable from Treasury associated with the missed payment, and this receivable that cannot be transferred.

Will interest be paid on any delayed payments? How about interest accruals?

Our best estimate is that there would be some sort of compensation in case of a delayed payment. This compensation is unlikely to take the form of interest accrual; in the latest guidance, SIFMA stated that interest on delayed payments of coupons/bills will not accrue interest as “Fedwire is not able to calculate or create any “make-up” interest payments.” The exact form of compensation is unclear but it is likely to take the form of a floating rate on missed coupon/bill payments. Moreover, the December 2021 Treasury Market Practices Group (TMPG) paper makes it clear such remuneration would require Congressional legislation, so there would be no certainty over this compensation at the time of a delayed payment.

However, there is precedent. In 1979, the Treasury was late in redeeming T-bills, with the payments on some bills delayed by three weeks, due to technical difficulties. In that event, investors who missed their interest or principal checks were reimbursed for the delay, even though Treasury felt it was on strong legal ground if it chose not to, given the precedent established in a prior legal case that held that “interest does not run upon claims against the government even though there has been a default in the payment of principal.”

What will be the status of Treasury collateral in the event of a technical default?

The status of Treasury collateral depends on the timing of Treasury’s notification of any delays in payments. If done in the timeframe discussed earlier, the security remains in Fedwire and is still transferable. As a result, it could in principal be used as collateral for repo and derivatives transactions, although possibly with higher haircuts.

If notification deadlines are not met, particularly for principal payments, that particular security is dropped out of the system and is no longer transferable, and as a result, cannot be used as collateral. It is possible that an OTC market may develop for securities that drop out of the system, but the likelihood of such an outcome is unclear at the present time.

Since Treasury securities do not have cross-default provisions, other Treasury securities that have not had a delayed/missed payment will remain transferable on Fedwire and can therefore continue to be used as collateral. It is important to note that usability as collateral does not imply unchanged haircuts or repo costs for these securities. With a default, even one that is technical in nature, market liquidity will likely be substantially impaired, and repo costs and haircuts on defaulted securities are likely to see a broad-based increase. However, given the low likelihood of default, we do not see this broad increase occurring without a rise in market perceptions of default (or the actual event of default).

How are exchange haircuts likely to be affected?

While a ratings downgrade could affect collateral haircuts, the bigger determinant is likely to be market liquidity and price volatility. Measures such as changing haircuts, concentration limits, and exclusion lists are likely to be taken only close to (or in the event of) default and will probably be based more on market behavior of these securities (as opposed to ratings) at that point. Delayed/missed principal repayments are likely to be more significant, and we do not believe missed coupons will result in a significant penalty. Furthermore, any measures taken are likely to be adopted on the basis of maturity buckets rather than specific CUSIPs (this has typically been the case). If our assumptions hold, in the event of a technical default, most of the changes applying to Treasury collateral will be focused on very short maturity debt, and are likely to have only a limited impact as a result.

Can defaulted Treasury securities continue to be posted as collateral for non-cleared OTC derivatives?

Under the US non-cleared margin requirements (NCMR) finalized by CFTC and prudential regulators, Treasury securities are considered eligible collateral even in the case of a missed payment. However, this is not the case under the UK and EU NCMR regimes. Thus, for any transactions facing counterparties in those regions, defaulted Treasury securities would be assigned zero collateral value, requiring the swap counterparty to substitute or post additional collateral. However, it is likely that swap counterparties are already preparing for this potential outcome and substituting out any Treasury securities at risk of default.

Will the Federal Reserve accept defaulted Treasury securities as collateral at the discount window?

As with the above question, we believe the Federal Reserve will accept defaulted Treasuries as collateral at the discount window. The Federal Reserve Collateral Guidelines list US Treasury securities as acceptable collateral with no restrictions, though according to the general acceptance criteria, “securities should not be subject to any regulatory or other constraints that impair their liquidation.”

The transcript of the August 2011 FOMC conference call around the first debt ceiling crisis offer some insight as well. In his presentation to the FOMC, Division of Monetary Affairs head Bill English said, “we suggested that Federal Reserve operations should treat defaulted Treasury securities in the same manner as nondefaulted securities, but with defaulted securities valued at their own market prices. This basic approach seems appropriate so long as the default reflects a political impasse and not any underlying inability of the United States to meet its obligations, so that all payments on defaulted securities would presumably be made after a short delay and the securities remained very low risk.”

Given this backdrop, it seems safe to say that defaulted Treasuries will remain eligible for the discount window, but the value used for borrowing against these securities is uncertain. Prior to this year, it would have been safe to assume these securities would be valued at market prices, as discussed in 2011. However, the introduction of the BTFP in the wake of this year’s regional bank crisis could change Fed’s decision making response, raising the risk the Fed may accept these securities at par instead of market value.

How will a technical default affect securities that are backed by the US government?

How securities that are “backed” by the US government are affected depends on the nature of the backing. We look at a few examples. First, we looked at “pre-refunded” municipal obligations, where such bonds are backed by Treasury securities held in escrow. The general rule of thumb on pre-refunded bonds is that the issuer is not on the hook for future principal and interest payments if the US fails to make payments on the Treasuries backing such bonds. Pre-refunded bonds that are defeased with marketable Treasury securities are safer as they have to build up cash before payments are made. However, pre-refunded bonds backed by Treasury securities issued specifically for refunding purposes (SLGS) are at greater risk — SLGS that have payments scheduled in a period of technical default by the US will likely have missed payments (there could be special provisions in some issues that avoid such a scenario).

Unlike pre-refunded munis, bonds that are guaranteed by the US government should see only a modest impact. This is because payments on these bonds would be missed only if the primary issuer also defaulted during Treasury’s technical default window, an extremely remote outcome, in our view. Bonds with explicit guarantees include those guaranteed by USAID, the Ex-Im Bank, Ginnie Mae securities, etc.

PEFCO secured notes have interest guaranteed by the Ex-Im Bank (the principal is secured by cash and securities). However, before Treasury is liable, loss reserves of the Ex-Im Bank provide an additional layer of protection. Other explicitly-guaranteed securities, such as those of Ginnie Mae, also have an additional layer of protection, in terms of FHA reserves before the US government would be responsible for missed payments. Finally, we note that Agency debt does not have an explicit guarantee, and as a result, Treasury is not legally liable for any missed payments by the GSEs.

Can Treasury prioritize payments?

Once all available extraordinary measures have been exhausted, it has been posited that Treasury can prioritize principal and interest payments over other outlays to avoid a technical default. We can use the transcript from the August 2011 FOMC conference call to gain greater insight into the Treasury’s ability to prioritize payments. The FOMC held an emergency conference call on August 1, 2011, and Louise Roseman, director of the Division of Reserve Bank Operations and Payment Systems, found that “[the Fed] had put procedures in place to address how government payments would be handled if the debt ceiling wasn’t increased in a timely way . . . The procedures are based on three principles. The first one is that principal and interest on Treasury securities would continue to be made on time. The second one is that other payments may be delayed. The third principle is that any payments that were made would be settled as usual.” Director Roseman described this process by which Treasury could implement this strategy, and indicated that Treasury had approved these procedures. This suggests that in a worst-case scenario, existing law does not preclude Treasury from prioritizing payments, but such actions would require guidance from Congress before proceeding in this manner.

Will money market funds be forced to liquidate defaulted Treasuries in the event of a technical default?

The implications of a technical default are complicated for MMFs, but ultimately, we believe these funds would not be forced to liquidate Treasury securities in a technical default. Taxable MMFs are significant owners of short-term Treasury debt, with $1.0tn in holdings as of April 30. Of this amount, $112bn was held in Treasuries maturing in June, with most of this amount ($103bn) held by Treasury-focused MMFs. Based on these April month-end numbers, Treasuries maturing in June comprised about 6.8% of all Treasury-focused MMFs’ holdings, only 0.2% and 0.1% of all government and prime MMFs holdings, respectively. However, this data reflects the period before Treasury moved its x-date forward to June 1, and the underperformance of early-June T-bills could be indicative of MMFs repositioning their portfolios away from these securities, suggesting the April data may overstate MMFs exposure.

Neither Rule 2a-7, nor any of the criteria governing rated funds’ investments, explicitly requires immediate liquidation upon default. The decision to sell or hold would most likely be left to the discretion of the boards of directors of individual funds. In the case of a solvent, high-quality government issuer facing a temporary payment delay, we believe few fund boards would choose to liquidate defaulted securities at distressed levels. Likewise, fund ratings criteria include provisions giving managers reasonable cure periods for dealing with defaulted securities.

In addition to holding Treasuries, MMFs also invest in repo collateralized with Treasuries. We estimate these holdings totaled $464bn (excluding ON RRP) at April month-end. Unlike Treasury holdings, this is mostly held by government MMFs ($288bn), followed by Treasury MMFs ($159bn) and prime funds ($17bn). As a matter of practice, short-dated coupons (e.g. 1-year and less) don’t get used as repo collateral very often, and probably comprise a small amount of MMF repo collateral. However, longer-maturity Treasuries with June coupon dates may well be included. Although a delayed coupon payment is less consequential from a risk perspective than a delayed principal payment, it is possible that MMF and other repo participants will begin excluding these from the lists of eligible collateral they are willing to accept, resulting in higher financing costs for these issues. Similarly, dealers may demand higher haircuts on bonds with coupons in June, which may also bias yields higher on these securities. But since the risk here is a delayed coupon and not the principal, the haircut increases may not be severe.

It isn’t evident that we will see outflows from MMFs before the drop-dead date, particularly since they continue to benefit from deposit migration out of the banking system, albeit at a much slower pace than at the onset of the banking turmoil. However, if a technical default does occur and MMFs witness outflows, certain MMF portfolios seem to be positioned well in the instance of redemptions. Specifically, MMFs with access to the Fed’s balance sheet hold a significant portion of their holdings at the ON RRP facility and could quickly liquidate to meet redemption needs. Indeed, government and prime MMFs held 42% and 31%, respectively, of their total portfolios at the ON RRP as of April month-end. Currently, MMFs represent 107 of the 138 counterparties with access to the Fed’s ON RRP facility. Of this amount, 48 are government MMFs, 30 are prime MMFs, 26 are Treasury MMFs, and 3 are tax-exempt MMFs.

As for Treasury MMFs that do not have access to the Fed’s ON RRP program (we estimate there are about 25 of these funds), their options are more limited in terms of how they could manage their liquidity. They could hold cash at their custodian, continue avoiding bills that mature surrounding early June, or invest in Treasury repo to the degree that the product is allowed in their investment policy. Each option has its drawbacks, but given the circumstances, we suspect most MMFs would attempt to place cash at their custodian to the degree the custodian is willing to temporarily hold cash on their balance sheet.