Wall St. Makes Fallback Plans for Debt Crisis

Financial investors on Wall Street are preparing for the possible collapse of the monetary system. The possible collapse and a downgrade of the US credit are causing a small panic and many investors are getting out of paper investments in fear that they will not hold their value.

LOUISE STORY and JULIE CRESWELL
On Wednesday July 20, 2011, 10:33 pm EDT
YAHOO! Finance

Lawmakers in Washington are racing to reach a deal to save the country from defaulting on its debt, but on Wall Street, financial players are devising doomsday plans in case the clock runs out.

These companies are taking steps to reduce the risk of holding Treasury bonds or angling for ways to make profits from any possible upheaval. And even if a deal is reached in Washington, some in the industry fear that the dickering has already harmed the country’s market credibility.

On Wall Street, Treasuries function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets. Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value. In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee.

The rating agencies, which control the fateful decision of whether the nation deserves to have its credit standing downgraded, are surveying other entities that would be affected by a United States default — like insurance companies and states — and issuing warnings that a United States downgrade could result in several other ratings cuts. States that might be downgraded, in turn, are trying to reassure the market that they could still pay their bills on time.

All these contingency plans hinge on the pivotal date of Aug. 2, when the Obama administration has said it will no longer be able to finance government obligations without raising the $14.3 trillion cap on government borrowing. If lawmakers do not act before then, it will be difficult for the Treasury to meet coming interest payments as well as obligations to government employees, vendors and programs like Social Security and Medicare.

Even though many on Wall Street believe that a default remains unlikely, the financial markets are starting to become agitated. Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

In the Treasury market, investors are starting to sell, fearing that the government will not make good on some interest payments that will be due next month. And complex financial instruments that will pay out if the United States defaults have become twice as expensive to buy as they were at the start of the year.

Analysts say the signs of panic are small for now.

“The metaphor is a pile of sand,” said Mark Zandi, the chief economist at Moody’s Analytics. “You keep putting one piece of sand on the pile, nothing happens, and then, all of the sudden it just caves.”

Several traders and bankers, including Mr. Zandi, said the imminence of a possible default was already damaging the United States’ standing as the most creditworthy country in the world. The tarnished reputation may linger, even if the government reaches a deal, and especially if the country’s financial books remain unbalanced.

“Our aura is diminished. You know people really view the U.S. as the AAA, the gold standard, and I think we’re tarnishing that,” Mr. Zandi said.

The government began preparing for much tougher borrowing conditions in the years since the financial crisis, shifting toward issuing longer-term debt. This was especially needed because much of the debt issued to cover the financial crisis of 2008 was short-term debt.

The United States still enjoys low borrowing costs — below 3 percent on a 10-year-note — but there is fear that the theatrics around the current debate will increase those costs. Low national borrowing costs translate into lower borrowing costs for American corporations and individuals.

Deterioration of investor confidence in the United States could also hurt the value of the dollar, according to William H. Gross, co-chief investment officer of Pimco, a bond fund based in California. Mr. Gross said he believed that the dollar would become weaker because of the country’s inability to deal with its rising deficit. Instead, he favors currencies in China, Canada, Brazil and Mexico. Compared with the balance sheet of the United States, he said, “their dirty shirts are much cleaner.”

In New York, the hedge fund KLS Diversified Asset Management has been accumulating cash to take advantage of profit-making opportunities if, for instance, investors are forced to sell cheaply because of a decline in the nation’s credit rating.

KLS was founded in the summer of 2008, and it weathered that storm in part by having lots of cash on hand, though back then it also was able to consider its Treasury holdings to be nearly as safe as cash. In the case of a United States default, KLS says it believes it can make money if investors flee the market, said Harry Lengsfield, a managing partner of the firm .

In his view, a default is unlikely but it should not be a surprise if one occurs. “It’s hard to argue that this case hasn’t been telegraphed and people haven’t been warned and warned again,” he said.

One of the worst possibilities that people in the financial industry, like Mr. Lengsfield, have been discussing is that scores of insurance companies, pension funds and mutual funds might be forced to dump their Treasury holdings. Some investors have rules that they cannot hold assets that are rated below AAA. It was this sort of rule that drove the forced selling of mortgage bonds during the financial crisis.

But in some cases, Treasuries may be exempt from the AAA rules.

Deborah Cunningham, who oversees $271 billion in money market funds at Federated Investors in Pittsburgh, said the funds themselves — even the Treasury-only money funds — would not be pressured to dump their holdings if there were a downgrade. Securities and Exchange Commission regulations say only that the funds have to invest in Treasuries, not that those Treasuries must be triple-A rated, she said.

Several weeks ago, Ms. Cunningham put plans in place to deal with a default. The firm will convene a teleconference with the boards of affected funds, she said, and, she is considering arguing for holding onto the federal debt.

“We have to justify to the board why we would want to continue to hold them, which might be because they are a high-quality, minimum-risk security,” Ms. Cunningham said.

Still, it is unclear whether other investors might stampede for the exits.

“The question I think investors are going to face is, Where do they go?” asked Ms. Cunningham. “Do they go to foreign banks? U.S. commercial paper issuers? U.S. agencies? Is there a safer haven than Treasury securities?”

As early as this spring, bankers began assessing the exposure of their trading positions if interest rates spiked, which would probably occur if there was a default. They have also been evaluating whether they may need to demand additional security deposits from trading customers.

At Wells Fargo, for example, executives said they had been keeping close tabs on the bond market and making sure they had ample cash on hand.

Timothy J. Sloan, Wells Fargo’s chief financial officer, said that if Congress could not reach a deal or if there was a spike in interest rates, his bank would be there to handle the situation. But in terms of specifics, he said, there was not much banks could do. “Because nobody knows what is going to happen, nobody knows how to prepare,” he said.

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