Probability of Debt Default Has Risen 300 Percent Since Start of Year: Report

The Department of the Treasury in Washington on Aug. 30, 2020. Andrew Kelly/Reuters

The probability of a catastrophic U.S. debt default has risen by 300 percent since the start of the year.

A recent report from MSCI, an American financial service provider, warned about the tripling of a debt default and said that Congress must pass a spending bill to avoid a disaster in the next few months.

“Implied default probabilities have increased to levels not seen since the 2013 debt-ceiling debate,” MSCI reported.

The financial services provider said that the probability of a U.S. debt default has soared from 3.3 percent at the start of January to 11.3 percent as of last week.

The Federal government hit its $31.9 billion debt ceiling on Jan. 19, forcing the U.S. Treasury Department to take extraordinary measures to avoid a potential default to keep government operations funded through June.

A divided Congress has so far not agreed to pass a spending bill to avoid a federal default, making some investors uneasy based on a rise in trading activity in credit default swaps (CDS) on the debt.

“Since mid-January, however, there has been a very noticeable pick-up in activity on U.S. CDS.”

Credit default swaps are a form of insurance against issuers not making their scheduled payments on their debt.

Credit default swaps were used by some investors who successfully bet against the housing market in 2008.

Protection payouts on CDSs are triggered when a debt payment is missed.

A Divided Congress in Conflict With WH Over Debt Ceiling

“Historically, CDS on the U.S. government attracted little interest in the market and were thinly traded. CDS on emerging-market sovereigns generated the vast majority of single-issuer trading,” reported MSCI.

Congressional Republicans are using the debt ceiling as leverage to force the Democrats to agree to spending cuts and reduce the federal deficit.

Speaker of the House Kevin McCarthy (R-Calif.) said in February that “defaulting on our debt is not an option. But neither is a future of higher taxes, higher interest rates, and an economy that doesn’t work for working Americans.”

The House GOP’s move on the debt ceiling could cause the government to default on its debt by the summer and President Joe Biden has warned his political opposition to not use the debt ceiling as a bargaining chip.

“The debt-ceiling debate has heated up in Congress, with estimates that the U.S. government’s ability to borrow may be exhausted sometime between July and September, assuming legislation has not been passed by then,” wrote MSCI.

MSCI reported that trading activity in credit default swaps for U.S. government one-year debt have skyrocketed since January, as investors buy insurance in case the much-feared fiscal disaster occurs.

“In the absence of legislative agreement, CDS trading volume on the U.S. government may continue to strengthen as summer approaches, and the possibility of missing payments on U.S. Treasurys looms larger,” MSCI said.

This is not the first time CDS spreads on U.S. government bonds have accelerated over congressional fights regarding the debt ceiling.

CDS spreads are approaching similar levels seen in previous political battles over the 2011 and 2013 debt ceilings, when Congress finally reached a last-minute agreement to avoid a default.

Extraordinary Measures May Be Taken to Avoid a Default

Some constitutional scholars also say that it is legally impossible for the Federal government to default on its debts, but the markets may say otherwise.

“Legal arguments have been made that the U.S. Constitution does not allow the government to default on its debt obligations. Nevertheless, a noteworthy pick-up in trading activity in credit-default swaps (CDS) indicates that some market participants challenge this view,” said MSCI.

Treasury Secretary Janet Yellen, said if the unprecedented event actually occurs, the consequences would spread beyond treasury holders not receiving their payments.

Millions of seniors may lose their social security benefits if the U.S. government defaults for the first time in history.

“It is unlikely that the federal government would be able to issue payments to millions of Americans, including our military families and seniors who rely on Social Security,” said Yellen.

“In the longer term, a default would raise the cost of borrowing into perpetuity. Future investments—including public investments—would become substantially more costly,” she continued.

A default could cause the world economy to tumble and unleash a wave of volatility in global interest rates, which are heavily attached to the nominally “risk-free” reputation of U.S. government debt.

“Major market dislocation and a sharp slowdown in economic activity could both be realistic possibilities” in the event of a U.S. default, said MSCI.

However, Biden could ultimately decide to avoid the risky debate in Congress via a loophole, by having the Treasury mint a $1 trillion platinum coin.

This radical and rare step could sidestep the legislative process, by depositing the $1 trillion platinum coin in the Federal Reserve and keeping the government afloat without having to formally issue any new debt.