Generals always fight the last war. And financial analysts always analyze the last crisis. So with the rapid approach of the October 17 debt-limit deadline, it’s no surprise the Excel-and-Powerpoint set are dusting off their histories of the Lehman Brothers debacle. Many Republicans may view blowing through the debt limit and potentially missing a few interest payments as no big deal. In a Pew Research Center poll released Monday, 54 percent of Republicans said the U.S. could go through the debt limit without major problems. Rep. Ted Yoho (R-FL) said not raising the debt ceiling would be a positive. “I think, personally, it would bring stability to the world markets,” he said.
But the giant conventional wisdom machine, of which I’m an integral cog, believes not raising the debt ceiling would be awful. It would be so bad it would dwarf the Lehman Brothers debacle. When the highly leveraged but poorly run investment bank was allowed to fail in September 2008, it triggered a lot of unexpected damage. The money-market fund industry nearly collapsed, as many money-market funds had Lehman Brothers commercial paper. Banks and financial institutions stopped lending to each other overnight. Trade financing froze. The stock market fell 28 percent in a few weeks.
A U.S. debt default, or the whiff of one, would be a much more significant financial event. As Yalman Onaran of Bloomberg noted, “The $12 trillion of outstanding government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy on Sept. 15, 2008.” True. But the increase in damage wouldn’t be arithmetic, it would be exponential—Lehman to the 10th power rather than Lehman times ten. A debt default, even if momentary and partial, wouldn’t be like blowing up a much bigger stick of dynamite. As Warren Buffett suggests, it would be like detonating a nuclear bomb.
Why would a default be so much worse than Lehman Brothers? It has largely to do with who owns U.S. government debt and how much debt those companies and institutions have. Lehman caused a company to fall, a sector to fall, and stocks to fall a bunch. A U.S. government default—or again, even the whiff of one—would cause all that to happen, plus it would bring down a bunch of governments and possibly ignite a revolution and a couple of wars.
Most people who own stocks pay for them with cash. Sure, some hedge funds use leverage, and some investors buy stocks on margin (effectively borrowing money from their broker), and certain exchange-traded funds allow investors to make leveraged bets on stocks. But the leverage surrounding stocks is never that great. So in the event of a sharp downdraft in stocks, even a very severe decline of 30 percent or 40 percent, several hedge funds and mutual funds might be wiped out and there would be widespread pain. But it wouldn’t cause massive institutions to fail.
It’s a different story with government bonds, as well as the mortgage-backed securities issued by Fannie Mae and Freddie Mac, which are, in the end, government bonds, as the two entities have been effectively nationalized. The biggest holders of U.S. government bonds and mortgage-backed securities are hugely leveraged financial institutions—chief banks and central banks. We no longer have unregulated investment banks with $33 of debt for every $1 of assets they have. But banks still have lots of leverage; they still borrow a lot of money, lend a lot of money, and used borrowed money to buy other assets. Citi in July said its bank holding company had assets equal only to about 5 percent of total obligations. JPMorgan Chase, which routinely boasts of its “fortress” balance sheet, says it has capital equal to about 10 percent of its balance sheet. That sounds like a lot. But if you’re leveraged to that degree and your assets lose a big chunk of their value, you’re in big trouble. Let’s say you have $10 in capital and $90 in debt—and you use that money to buy $100 in assets. If the value of your assets falls by 10 percent overnight, your capital is gone.
Well, Treasury bonds and mortgage-backed securities account for a big chunk of American banks’ assets. Since they have historically been so safe, banks regard them as a substitute for cash. All in, American banks own about $1.8 trillion in debt issued by the government and government agencies. Should they lose a few percentage points of their value overnight, or over the course of a day, the banks would be in big trouble. Treasury bonds also are used as collateral for trades. And when the value of the collateral declines, the person on the other side of the trade can ask for more collateral. What holds for American banks also holds for European and other foreign banks. They are highly leveraged institutions that keep a good chunk of their assets in instruments that are supposed to be safe, reliably pay interest, and don’t fluctuate in value much from day to day. The global financial system is simply not designed to weather a quick, swift decline in the value of U.S. government bonds.
The Federal Reserve, for example, has $3.4 trillion in assets, at last count. That includes about $2 trillion in U.S. government bonds and about $1.3 trillion in mortgage-backed securities. Oh, and foreign central banks have gorged on U.S. debt. According to the Federal Reserve, foreign central banks collectively hold $2.9 trillion in Treasury debt and $315 billion in debt issued by U.S. mortgage agencies such as Fannie Mae and Freddie Mac. These holdings are concentrated in the world’s second- and third-largest economies. As The Wall Street Journal notes, in September, China had $1.277 trillion in debt issued by the U.S. Treasury. Japan had $1.135 trillion.
So anything that would reduce the value of government or agency debt rapidly overnight would unleash a tsunami of value destruction around the world. These central banks would suddenly find themselves sitting on hundreds of billions of paper losses. Any analyst who says he or she knows with certainty what the social, economic, and geopolitical impact of the overnight destruction of hundreds of billions of dollars in value would be is likely blowing smoke. Perhaps highly nationalistic countries would take this kind of financial damage lying down. Perhaps they wouldn’t.
Ultimately, the Lehman damage, while massive, was limited. And that’s because once the bank fell, the government—the Federal Reserve, Treasury, the Federal Deposit Insurance Corporation, the taxpayers—was waiting with its printing presses, guarantees, and bailout facilities. In September and October 2008, the U.S. government effectively substituted its credit for that of the private sector. That was enough to stop the panic. But it’s unclear how effective the Fed could be in a situation where its assets are shriveling. A debt default would be much more like September 11, 2001, than September 15, 2008. The first responders would be among the hardest hit.