Wall Street's Getting Nervous About a Default

“Don’t go to a butcher for back surgery.”  My Air Force veteran father used to say that.  It meant: don’t listen to folks about important matters unless they really know their business.

He had been in the Strategic Air Command during the height of the Cold War, stationed at MacDill Air Force Base.  A barber had opined to him, “Well, I guess you guys would have plenty of time to get away safely if you ever did have to drop one of those atomic bombs.”

My father looked at him and said, “How would you know that?  Folks I fly with aren’t so sure.  I think I’d rather not test that theory.”

I am reminded of that as I listen to those Republicans who claim that a small default on payment of principle and interest to creditors would not roil credit and equity markets.  Indeed, 17 Republican Senators have sent a letter to Treasury Secretary Tim Geithner saying that if a default on sovereign debt payments occurs, it is all Geithner’s fault.  The “reasoning” for this statement is the fact that the Treasury takes in much more money than is needed to pay outstanding debt on time and in full, so it’s Geithner’s responsibility to make sure that happens.

What they don’t say is that a government services disruption of an unprecedented nature would then occur—after all, if Treasury pays the debt cost, it has to cut spending somewhere else.  And in a cash-in/cash-out system, only hundreds of thousands of layoffs and the issuance of IOUs to contractors, among other chaotic choices, would satisfy that “stubborn fact of life.”

Apparently, the belief that no one in the United States would notice such layoffs, and the resulting economic disruption, is held as an article of faith by folks who ought to know better.

In a separate letter, 23 GOP Senators wrote to President Obama calling upon him to create a budget plan that would assume no increase in the government’s ability to borrow.

And, Stanley Druckenmiller reprises his 1995-96 role in a budget/debt debate by once again contending that a short term default wouldn’t disturb markets if a major deficit reduction plan emerged.

(If I were 24 years old, seven feet tall, with a superior hook shot and athletic ability, I would be the center for the Los Angeles Lakers.  That is about as relevant as Druckenmiller’s hypothetical discussion of markets’ reactions to something that isn’t going to happen.)

When politicians talk about politics, it is wise to listen.  They do it for a livelihood and if they are wrong, they lose their jobs.  Just like butchers and back surgery, however, don’t listen to politicians with little or no experience in modern financial engineering when they predict market behavior.

Listen to market participants, who will lose their jobs if they are wrong.

Or watch the rising costs of Credit Default Swaps (CDS) in the marketplace.  Without getting too technical, when those costs rise, it means that markets are losing faith in a form of financial product—in many cases, national sovereign debt.  The CDS market forecast the late and unlamented financial meltdown of three years ago before almost any other market mechanism.

According to the Depository Trust and Clearing Corporation, which gathers information about global CDS, global traders and investors have increased their purchase of this form of insurance, doubling the level of such insurance on American sovereign debt in 12 months.

So, who you gonna believe—the markets or the politicians?

Here are a couple of ways to make that decision:

*ask the next Senator you see about the Credit Default Swap situation;

*ask the next Congressman you run across at a fund-raiser about the size of the global derivatives market;

*ask the next Washington, D.C. politician you meet how many swaps and derivatives contracts he or she has personally arranged.

Then, ask a Wall Street fixed-income trader the relationship between United States sovereign debt issuance and the global markets in these arcane financial instruments.  Finally, ask this trader for the legal and market implications of failures of counterparties to be able to perform as contractually obligated because the United States defaulted “just for a little while” on its debt payments.

And, the coup de grace, just ask anyone if they think it is wise to test a theory about marketplace behavior when failure of that test could severely undermine the confidence of markets all over the world about the reliability and judgment of United States policymakers.

A theory gaining ground on Capitol Hill posits that with all the turmoil in North Africa, the Middle East, in Japan, and with wars in Iraq, Afghanistan, and Libya, American Treasury securities will continue to be the first choice with global investors who want to protect their capital.  That’s like saying that we should foul our own nest because others’ nests are even worse.

Raise the debt ceiling (as Congress assuredly will do in the most painful and chaotic way possible, causing maximum anxiety) or don’t raise the debt ceiling (and let government services collapse, causing maximum anxiety).   Are these really the only choices that policymakers can conceive?

As my colleague Jay Powell wrote in the Wall Street Journal this past week, we are beginning to have a serious discussion about America’s fiscal future.  Why mess up this long-overdue, critical, discussion on policy with all the political theatrics and threats of the past three months?

And, the final irony: in private, a majority of Congressmen in both parties  would likely admit that we have to raise the debt ceiling, we have to begin to address Medicare and Social Security solvency, and other entitlements, and that revenues have to be part of the solution.

But they are afraid to say this truth publicly.  Their polls tell them that their jobs are at stake and truth often suffers in such circumstances.

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