What would happen if the US defaulted on its debt (2023)

The US debt limit has been reached and the Treasury Department isfind ways to save money. With the maneuvers exhausted, what previously seemed unfathomable may become reality: the default of the United States.

What happens next?

The far-reaching effects are difficult to predict: from shock waves in financial markets to bankruptcies, recession and potentially irreversible damage to the nation's long-standing role at the center of the global economy.

The likelihood of default remains low, at least based on assurances from opposing legislators that an agreement will be reached to increase or suspend thedebt limitand the long odds implied by trading in certain financial markets. But as the day approaches when the United States starts to run out of money to pay its bills - which can beas soon as June 1st— investors, executives and economists around the world are imagining what might happen immediately before, during and after, laying out contingency plans and puzzling over largely untested rules and procedures.

“We're in uncharted waters,” said Andy Sparks, head of portfolio management research at MSCI, which creates indices that track a wide range of financial assets, including the Treasury bond market.

On the brink of default, a “terror scenario” emerges.

Some corners of financial marketshave already started to shake, but these ripples pale in comparison to the tidal wave that forms as the pattern approaches. The US Treasury's $24 trillion market is the main source of funding for the government, as well as the largest debt market in the world.

The Treasury market is the backbone of the financial system, essential for everything from mortgage rates to the dollar, the most widely used currency in the world. Treasury debt is sometimes even treated as the equivalent of cash because of the government's creditworthiness guarantee.

Destroying trust in such a deeply rooted market would have effects that are difficult to quantify. Most agree, however, that a default would be "catastrophic," said Calvin Norris, portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a horror scenario.”

A missed payment triggers a trading frenzy as markets begin to unravel.

The government pays its debts through banks that are members of a federal payment system called Fedwire. These payments then flow through the market pipeline, ending up in the accounts of debt holders, including individual savers, pension funds, insurance companies and central banks.

If the Treasury Department wants to change the date it repays investors, it needs to notify Fedwire the day before the payment is due, so investors know that the government was about to default the night before.

There is more than $1 trillion in Treasury debt maturing between May 31 and the end of June that could be refinanced to avoid default, according to analysts at TD Securities. There is also $13.6 billion in interest payments due, spread across 11 dates; that means 11 different opportunities for the government to miss a payment over the next month.

Fedwire, the payment system, closes at 4:30 pm. If a due payment is not made by that time at the latest, the markets will begin to unravel.

Stocks, corporate debt and the value of the dollar would likely plummet. Volatility can be extreme, not just in the United States, but around the world. In 2011, when lawmakers struck a last-minute deal to avoid breaching the debt limit, the S&P 500 fell 17% in just over two weeks. The reaction after a default can be more severe.

A cascade of ratings downgrades creates “madness” for bondholders.

Joydeep Mukherji, lead credit rating analyst for the United States at S&P Global Ratings, said an unpaid payment would result in the government being considered in "selective default", whereby it has chosen to renege on some payments, but is expected to keep paying other debts. Fitch Ratingsalso saidwould lower the government's rating in a similar way. Such ratings are usually assigned to distressed companies and government borrowers.

Moody's, the other major ratings agency, said that if the Treasury defaults on one of the interest payments, its credit rating will be downgraded one notch to just below its current maximum rating. A second missed interest payment would result in another downgrade.

A range of government-linked issuers would also likely suffer downgrades, Moody's noted, from agencies that underpin the mortgage market to hospitals, government contractors, railroads, power utilities and defense companies dependent on government funds. It would also include foreign governments with guarantees on their own US debt, such as Israel.

Some fund managers are particularly sensitive to ratings downgrades and may be forced to sell their Treasury holdings to comply with rules on the minimum debt ratings they can maintain, depressing their prices.

The financial system's plumbing freezes, making trading more expensive and difficult.

Importantly, the default of one government bill, note or bond does not trigger the default of all government debt, known as “cross default,” according to the Securities Industry and Financial Markets Association, an industry group. This means that most of the government's debt would remain current.

That should limit the effect on markets that rely on Treasury debt as collateral, such as trillions of dollars in derivative contracts and short-term loans called repurchase agreements.

Still, any collateral affected by a default would need to be replaced. CME Group, a large derivatives clearing house, said that while it had no plans to do so, it could ban the use of short-term Treasuries as collateral or apply discounts to the value of some assets used to secure transactions.

There is a risk that the financial system's tubes will simply freeze as investors rush to reposition their portfolios while the big banks that facilitate trading pull away from the market, making it difficult to buy and sell virtually any asset.

Amidst this turmoil in the days after default, some investors may have a big windfall. After a three-day grace period, about $12 billion in credit default swaps, a type of protection against default on a bond, can be triggered. The decision on payments is made by aindustry committeethis includes large banks and fund managers.

The nation's global financial reputation is permanently diminished.

As panic subsides, confidence in the nation's pivotal role in the global economy may be permanently altered.

Foreign investors and governments hold $7.6 trillion, or 31%, of all Treasury debt, making them vital to the favorable financing conditions the US government has long enjoyed.

But after a default, the perceived risk of holding Treasury debt could increase, making it more expensive for the government to borrow for the foreseeable future. The dollar's pivotal role in world trade could also be undermined.

Higher government borrowing costs would also make it more expensive for companies to issue bonds and borrow money, as well as raise interest rates for consumers who take out mortgages or use credit cards.

Economically, accordingwhite house predictionseven a brief default would result in half a million lost jobs and a somewhat shallow recession. A prolonged default would push those numbers to a devastating eight million job losses and a severe recession, with the economy shrinking by more than 6%.

These potential costs — unknown in the aggregate but widely considered enormous — are what many believe will motivate lawmakers to reach an agreement on the debt limit. “Every leader in the room understands the consequences if we fail to pay our bills,” President Biden said in a speech on Wednesday, as negotiations between Democrats and Republicansintensified. “The nation has never defaulted on its debt and never will,” she added.