Thinking the Unthinkable Fitch

8/6/2019 Thinking the Unthinkable Fitch

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Sovereign/United States of America

Thinking the Unthinkable What if the Debt Ceiling Was NotIncreased and the US Defaulted?

Senior Unsecured Rating AAAShortTerm Rating F1+Outlook Stable

The United States government reached the statutory debt limit of USD14,294bn on May 16, 2011.Treasury Secretary Geithner has authorised extraordinary measures that, according to the latestTreasury projections, will allow the government to extend its borrowing authority until August 2.According to Secretary Geithner, after this date, the federal government will have no remainingborrowing authority and cash balances will be inadequate for it to securely meet its commitments,

potentially including debt service.

In Fitch Ratings opinion, agreement will ultimately be reached on raising the debt ceiling and the USgovernment will make full and timely payments on its debt. Nevertheless, such a tail risk for theworlds most important fixedincome issuer warrants comment as well as clarity from Fitch for users ofits ratings as to the potential consequences of a failure to raise the debt ceiling, including a default onUS Treasury securities.1

Summary Fitch expects the debt ceiling to be raised before the US government faces the prospect of failing to

honour its commitments to suppliers of goods and services as well as to holders of Treasuries.

If the ceiling is not raised by the date projected by the Treasury and timely and full payment on itsobligations, including on Treasuries, is not secure, the US sovereign rating will be placed on Rating

Watch Negative (RWN). (The current date projected by the Treasury is August 2.)

In the extremely unlikely event that a coupon or principal payment on a rated US Treasury security ismissed, the default event will be recognised with downgrades of the affected securities from AAAto B+.

Extensive payment arrears to suppliers of goods and services to the government as a result of theprioritisation of debt service would not be treated as a sovereign default from a rating perspective.Nonetheless, it would damage perceptions of US sovereign creditworthiness and signal growingfinancial distress, and prompt placement of the US sovereign rating on RWN.

If the default event persists or renders a significant portion of Treasuries nonperforming, the USsovereign rating would be downgraded from AAA to Restricted Default (RD). Failure to honourabout USD25bn of coupon payments on more than USD1trn of Treasury securities on August 15 would

result in the US sovereign rating being downgraded to RD.

If the US sovereign rating were downgraded to RD, there may be negative rating consequences forthe entities whose issuer and issue ratings are underpinned by US sovereign support. Fitch willconsider the appropriateness of any rating changes for such entities in the context of the potentialpath of the US sovereign rating as well as the standalone credit profiles of the affected issuers.

The ratings of US states and municipalities would not be directly and immediately affected.

A missed payment on a Treasury security, albeit shortlived, would place the US AAA status at risk.In the event that the US sovereign rating is lowered to RD, the rating would be unlikely to revert toAAA once the default is cured.

1 Rating actions are determined by the appropriate rating committee incorporating the relevant information, including informationnot available at the time of this report.


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Thinking the Unthinkable What if the Debt Ceiling Was Not Increased and the US Defaulted?June 2011 2

The Debt CeilingA statutory limitation on federal debt is a longstanding feature of the US fiscal framework and applies to

nearly all Treasury debt, whether held by the public or by government accounts.2 The statutory debtlimit has been changed many times ten times in the last decade and twice in 2009 alone and waslast increased to the current limit of USD14.294trn on February 12, 2010. Each time the statutory debtlimit has been reached, the US Treasury Department has resorted to taking extraordinary measures(such as suspending the issue of Treasury securities for investment by government pension and socialsecurity funds) in order to meet its current obligations without breaching the debt ceiling.

0

3

6

9

12

15

FY90 FY93 FY96 FY99 FY02 FY05 FY08 Apr 11

Debt ceiling Debt st ceiling Debt held by public

(USDtrn)

US Federal Debt and Debt Ceiling

Source: US Treasury and Fitch

Nevertheless, an increase in the debt limit has never been delayed to the point where the government

has been rendered unable to continue to finance its current operations (such as paying social securityand other benefits) and to make timely interest payments or redeem maturing Treasury securities.

Rating Response to Previous Debt Ceiling CrisesThere have been a number of episodes when the government has reached the debt limit, including in2002, 2003, 2004 and 2006. However, the much smaller fiscal financing need and broad politicalconsensus on the necessity of raising the limit before the US government was at risk of failing to honourall its obligations meant that a rating action was not warranted.

The only time that Fitch has taken a rating action because of the risks to timely debt service posed bydelays in raising the debt ceiling was in 1995. At that time, concerns were widespread that the politicalstandoff between President Clinton and Congress led by then Speaker of the House of RepresentativesNewt Gingrich, which had resulted in a prolonged government shutdown, could also prevent timelyagreement on an increase in the debt ceiling necessary for the US government to continue to honour its

obligations. On November 13, 1995, Fitch IBCA (a predecessor to Fitch Ratings) placed the US sovereignrating on RWN, citing the possibility of a default on interest payments due on Treasury securities. The USAAA sovereign rating was affirmed and the Watch lifted on April 1, 1996, following an increase in thestatutory debt limit from USD4,900bn to USD5,500bn.

In light of the experience of 1995 and subsequent episodes when the debt ceiling has been reached andsubsequently raised in a timely manner, as well as the recent lastminute agreement reached betweenthe Administration and Congress that prevented a government shutdown in April of this year, Fitchdoes not believe that it would be appropriate to place the US sovereign ratings on RWN at this time.However, the US sovereign rating will be placed on RWN if, contrary to expectations, an increase in theceiling has not been enacted by August 2 (or the latest date specified by the most recent Treasuryprojection as to when the US government will not be able to securely honour its commitments).

2 For the purposes of its fiscal and sovereign credit analysis, Fitch uses the consolidated measure of general government debt thatexcludes debt held by government agencies and accounts and includes the debt of state and municipal authorities.


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The rationale for placing the US sovereign rating on RWN if the ceiling is not raised by August 2 is simple:from that date, the window before raising the ceiling and the US government failing to honour a debt

obligation will rapidly close given monthly budget deficits averaging some USD124bn. With an annualbudget deficit equivalent to around 10% of gross domestic product, balancing the budget is not a crediblealternative to raising the debt ceiling in the near term if a sovereign default is to be avoided.

240

180

120

60

0

Oct 08 Jan 09 A pr 09 Jul 09 Oct 09 Jan 10 A pr 10 Jul 10 Oct 10 Jan 11 A pr 11

Monthly Federal Budget Deficit

(USDbn)

Source: CBO

The Economic and Financial Consequences of Technical DefaultA number of commentators have described a socalled technical default scenario whereby the USgovernment misses a coupon or principal payment on outstanding Treasury securities due to delays inraising the debt ceiling rather than a deterioration in government solvency and consequently the defaultis cured very quickly. This Comment does not offer a substantive analysis of the economic and financialconsequences of a technical default, which would be, inevitably, highly speculative. 3 However, such anevent would be without precedent by the issuer of the global reserve currency and would pose a systemicthreat to US and global financial stability. As the largest and most liquid market in the world, US

Treasury securities are generally perceived as the safest US dollar asset from a liquidity as well as acredit risk perspective an assumption that would be challenged by even a shortlived technicaldefault. For example, it could prompt a flight from US Treasury market by moneymarket funds andother highly riskaverse investors such as (the liquidity portfolios of) central banks and sovereign wealthfunds. JP Morgan estimates that almost USD4trn of Treasuries are used as collateral for repo agreementsalone.

For USbased investors, Treasuries would likely remain an important component of their investmentportfolio even after a technical default, and the absence of a serious nearterm contender to the USdollar as the preeminent global reserve currency would imply continuing, albeit diminished, overseasdemand. Nonetheless, the failure of the US government to honour its obligations in a timely fashion,albeit even for a few days, would, in Fitchs opinion, materially damage the US governments reputationas a trustworthy and reliable borrower and lead to a permanent repricing of its cost of borrowing.

The Rating Implications of a Technical DefaultFitch would only recognise a sovereign default event if there was failure to honour on due date interestand/or principal payments due on US Treasury securities. Widespread and prolonged delay to suppliers ofgoods and services, including salary payments to federal employees, would damage perceptions of USsovereign creditworthiness but would not in itself constitute an event of default from Fitchs sovereignrating perspective. In contrast to many other sovereign borrowers, debt service is not accorded priorityover other financial obligations of the US government. Nonetheless, even if the Treasury were able toovercome any legal and operational obstacles to the prioritisation of debt service and other obligationsessential to the integrity of the state, such as those related to defence and national security, extensivepayment delays on other obligations would confirm that the US government was in severe financialdistress and that a failure to make payments on rated Treasury securities (bills, notes and bonds) waspotentially imminent. If it had not already done so, in such circumstances Fitch would place its sovereign

rating of the US on RWN.

3 Research report by JP Morgan, The Domino Effect of a US Treasury Technical Default, April 19, 2011, is an excellent attempt todo so.


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In the event that the US sovereign rating is placed on RWN, the ratings of financial institutions and otherentities that are directly underpinned by support from the federal government would similarly be placed on

RWN (see Table 1 for a listing). However, the rating of US states and municipalities would at least initially beunaffected as their current ratings do not rest upon explicit support from the federal government4.

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10

20

30

40

50

60

70

04 Aug 11 Aug 18 Aug 25 Aug 01 Sep 08 Sep 15 Sep 22 Sep 29 Sep

Notes Bills Coupons

Maturing Treasury Bills, Notes and Coupon Payments, AugSep 2011

(USDbn)

Source: Fitch estimates based on US Treasury data

Under the scenario whereby the debt ceiling has not been raised by August 2 and the Treasury hasexhausted its borrowing authority and does not have recourse to further extraordinary and contingencymeasures a set of circumstances that Fitch currently judges to be extremely unlikely the timelyservice of Treasury securities (bills, notes and bonds) would be at risk. The first test for a marketable(and Fitchrated) Treasury security would be a USD30bn Treasury bill maturing on August 4.5 Table 2provides the details of Treasury bills, notes and bonds maturing and with coupon payments due inAugust, including their rating and CUSIP.

In the event that the Treasury bill maturing on August 4 is not repaid in full on that date, Fitch would

mark the default by lowering the specific issue rating from AAA to B+, the highest rating for a securityin default on the expectation of full or near full recovery. However, Fitch would not necessarily placethe US sovereign rating into default if it judged at the time that the nonpayment would be cured in full(including the payment of accrued interest) before the next Treasury bill matures on August 11(USD27bn).6

In practice, the Treasury may be able to refinance maturing bills without breaching the statutory debtlimit. More problematic in terms of refinancing while remaining at the debt ceiling would be USD25bn ofcoupon payments and USD27bn of Treasury Notes payable on August 15. In the event that couponpayments are not made on August 15, more than USD1trn around 10% of marketable Treasury debt would effectively be nonperforming and downgraded to B+. At this point, the US government wouldhave moved beyond what could be described as a technical default and Fitch would downgrade the USsovereign issuer rating as well as the issuespecific ratings. The US sovereign issuer rating would beplaced in the RD category until the default event was cured.

If the US sovereign rating were downgraded to RD, there may be near and longerterm negative ratingconsequences for those entities whose issuer and issue ratings are underpinned by US sovereign support.Specifically, this currently applies to the GSEs (Fannie Mae and Freddie Mac) and the Federal Home LoanBanks. Fitch will consider the appropriateness of any rating changes for such entities in the context ofthe potential path of the US sovereign rating as well as the standalone credit profiles of the affectedissuers. The US AAA Country Ceiling that reflects Fitchs assessment of the risk of extensive controls onthe crossborder movement of capital and the convertibility of the US dollar would, however, likelyremain unchanged.

4 For example, the ratings of prefunded municipal bonds that rely on payments from the federal government could be affected.5 By market convention, Fitch assigns the relevant longterm localcurrency rating to government shortterm bills and the short

term rating is only assigned to commercial paper programmes.6 There is a parallel when Peru did not make a due coupon payment of USD80m on some of its Brady bonds in September 2007 as itfeared attachment of the payment by a creditor with which it was in dispute. At the time, Fitch described the event as atechnical missed payment and did not take negative rating action, though the missed payment was cured in full during the 30day grace period.


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mailto:[email protected]:[email protected]


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Thinking the Unthinkable Fitch