With less than two weeks to go until the debt ceiling is breached, there’s a lot of talk about the risk of a U.S. “default” and what happens if the U.S. does default.
Unfortunately, there’s a lot of sloppiness about the meaning of this word, default.
In a note examining the debt ceiling, Goldman Sachs provides a service talking about some meanings of the word, and how it’s used:
The term “default” has been used to mean a number of different things in the context of the debt limit. The media often refers to a failure to extend the debt limit by the deadline as a form of default, while lawmakers sometimes refer to any failure of the Treasury to make a scheduled payment to an individual or business as a default. The two areas where a default is more narrowly defined are the rating agencies and U.S. sovereign credit default swaps (these definitions are independent of one another—a default in the eyes of a rating agency is not equivalent to a default for CDS purposes, and vice versa):
- Rating agencies define default as a failure to service a debt obligation. In the event that the Treasury fails to make a scheduled interest or principal payment, the rating would be moved to “selective default” or its equivalent until principal and interest are paid in full. After the default was cured, the rating assigned to the US would presumably be lowered but by how much is unclear and would depend on the specific circumstances. Such a downgrade could also affect other ratings dependent on the US federal government, such as the GSEs or municipalities. As we have noted in prior research, many investment mandates allow investment in Treasury debt or sovereign debt generally, without regard to the rating of that debt, so a downgrade should not generally affect the ability of major holders to continue holding securities.
- Credit default swaps could potentially trigger if the Treasury missed a payment, but it would depend on how long payments were delayed. According to ISDA, US CDS is triggered by a “failure to pay, repudiation/moratorium, and/or restructuring.” Failure to pay would in theory be a risk if the debt ceiling were not raised and Treasury were not able to find other ways to make payments. However, US sovereign CDS has a three-day grace period on failure to pay, meaning that the Treasury would still be able to make a payment within three days and avoid triggering a credit event. Overall CDS exposure is fairly modest, at $23 billion gross exposure and $3.3 billion net exposure at the end of September. Since firms’ net exposure is reduced by the recovery value of the underlying obligation—which in the case of Treasuries should be essentially full recovery value—the triggering of CDS not only seems unlikely but would also probably have little consequence if it did occur.
The prospect of a U.S. “default” sounds like a terrible thing, but it seems safe to say that a “default” on U.S. contractor obligations (or military pay or Social Security) would not have the kind of instantaneous, catastrophic ripple effects the way an actual missed Treasury payment would.
It’s tempting to say that the word “default” should only be used in the technical financial sense (defaulting on debt), though arguably from a broader perspective, a country failing to make some legal obligations (say, to its citizens) has cast its creditworthiness in doubt, even if it’s still making debt payments.
Bottom line, not all “defaults” as used by the media or by sell-side analysts are the same. Some are much scarier.