IVN News

How a Debt Default Would Affect You

Yesterday, I paid a bill. It was roughly $172; the last in a series of payments for a $1,100-plus medical device that I bought last year to treat sleep apnea. My creditor, Fort Worth-based Rhema Medical, accepted the credit card payment that I placed over the phone.

On November 2, I expect to pay that credit card bill with earned income, hopefully netting me a cash-back bonus and boosting my overall credit score. Like many Americans, I hope to one day furnish my credit score as proof that I can be trusted to pay when I apply for an auto loan, a mortgage, maybe even when I co-sign for a Parent PLUS loan one day (and junior, you’re going to college).

My credit score is a double-edged sword, however. If I were to have ignored the bill for that medical device, it’s likely that Rhema — a self-interested company which, like any other, needs to make payroll, pay investor dividends, turn a profit — would have eventually forwarded my name to a collections agency and notified credit ratings agencies of my risk as a borrower.

This is the situation that the United States faces at midnight on Thursday — only the bill is for $16.7 trillion in debt held by domestic and foreign creditors and the credit card is yet-to-be-approved legislation that authorizes the Treasury Department to make payments for debt we already incurred.

According to CNN, on Wednesday afternoon, the only promise of a deal for a badly divided Congress has been a Senate proposal cobbled together at the eleventh hour by majority and minority leaders Sens. Harry Reid (D-NV) and Mitch McConnell (R-KY). The bill awaits a vote in the Republican-controlled House of Representatives, which is torn between pragmatists and hard-liners, with The New York Times reporting that some of the latter even now dispute the consequences of a default.

I’m not writing to discuss who’s right or who’s wrong. The entire situation is wrong. We shouldn’t be worrying about a self-created political crisis that threatens to imperil our good faith and credit as a nation with investors at home and abroad — and yet here we are, four years into an economic recovery from the last recession, with lawmakers scrambling like students in a group project on the day of a deadline.

Just as there are consequences for me if I fail to pay a bill on time, there are problems that snowball into a vicious cycle for our nation and others if we don’t raise our debt-ceiling limit by the deadline.

1. Officials will need to decide who we pay — leaving creditors to call in debts and hike interest rates.

Much has been said about what would happen if we defaulted on interest and principal payments we make every week to debt holders that include foreign governments, pensioners, and private investors.

Treasury Secretary Jack Lew explained in committee testimony on Thursday last week that we would “run out of borrowing authority” to continue making our payments. He added that U.S. bond-holders—perhaps concerned about how long Congress will hold off on renewing that authority—could well call in more than $100 billion of their bills that the United States “rolls over” every week. That scenario would “unexpectedly dissipate our entire cash balance” and exhaust the extraordinary measures that deniers say Treasury could use to continue satisfying our creditors.

Even if the majority of these debt-holders decided to continue investing in Treasury bonds and securities, however, the outlook is less certain with creditors like China and Japan, which NPR reports own $1.3 trillion and $1.1 trillion — roughly one-sixth total — of U.S. debt. The former may not make a run immediately, but China would almost certainly begin selling more treasuries over the long run, increasing Treasury yields, which interest rates track closely for just about everything — from auto loans to student debt to mortgage applications and home loans.

2. Our risk outlook will increase as a nation, discouraging our investors and lenders.

On Tuesday, Fitch Ratings, one of the big three debt-rating firms, placed the U.S. federal government on credit-watch negative. This serves as a warning to investors that might otherwise buy bonds, allowing us to borrow. Credit watches historically also often precede downgrades.

You may remember that another firm, Standard & Poor’s, famously slashed our creditworthiness grade after our last round of deficit and debt-ceiling brinkmanship in 2011. That took us from a sterling AAA bond rating to the less-reliable AA, rattling investors and causing the Dow Jones Industrial to fall 635 points on the same day.

Since then, according to the Huffington Post, investors have continued to buy up Treasury bonds because the world still sees our debt as safe, particularly as Europe continues to slide in growth — but that’s because the United States hasn’t defaulted since 1812.

Those countries that have been unable to pay on time illustrate more alarming parallels. (See below for Italy and Greece, for example)

3. Global markets could see mass selloffs, shocking consumer confidence and driving the world economy back into recession

The U.S. bond has only benefited from recent default crises in the euro zone. Why? Because investors worldwide still see the bond as our word and know that the United States will meet its financial obligations.

Hence why, when fears surfaced of a “Grexit” (wonk-speak for a Greek exit from the European Union), the big three debt-rating firms unanimously placed Greece under credit-watch negative. Investors sold off their Greek debt and bought up U.S. debt. Bond values went up, and interest rates, along with Treasury yields, fell accordingly, helping ease pressure on our tight lending environment and inspiring those record-low mortgage rates we saw over the last few years.

Reverse the situation and the United States could—if our creditworthiness fell, if lawmakers continued to play chicken with the possibility of a default—end up like Greece, only with much wider-reaching implications for global markets. If we defaulted, now or ever, investors could sell off their U.S. bonds en masse. This would raise interest rates, shock consumer confidence, lower spending habits, and scare off investments, creating the conditions for a recession all over again.

4. Banks will stop borrowing and begin to shutter . . . and the federal government will need to pay for their liquidation and insure depositors.

Federal regulations require banks to maintain capital reserves for crises such as, say, a recession. When signs begin to appear that the market isn’t stable, banks tighten credit requirements in order to shore up those reserves. This is what happened in 2008 when the catchphrase “credit crunch” became popular in the newly crimped lending environment.

Consumers of all kinds—from businesses to homeowners—paid the price. Tight lending standards squeezed consumer confidence and spending, which led to mass layoffs and decreased GDP year-over-year—which affected elections, giving politicians a mandate to pass stimulus legislation which, in turn, inspired the conservative backlash in 2010.

But one of the most nefarious and nearly unstoppable reactions in a recession—as we know from the last four years—is the impact on lenders in the first place. The snowball effect forces banks to shutter, obliging the FDIC—yes, the federal government—to step in, backstop depositors, buy toxic assets, pay for liquidation, and then spend years in litigation to settle with the purchasers or past bank owners in order to make up costs and replenish its insurance fund.

According to TheStreet.com, this expensive process sapped more than $82 billion from the FDIC’s Insurance Fund as the agency closed and liquidated 417 banks and thrifts between 2008 and 2012. Try that again anytime soon and — as the Wall Street Journal warned at the height of the last crisis in 2009 — American taxpayers may have to bail out the FDIC.

This is all to say that defaults—even those that Treasury may hypothetically be able to endure for a few days or weeks—do not come without a price.

Just as I would be forced to pay higher borrowing costs on that sleep apnea medical equipment if I ignored my bill, a fiscally irresponsible Congress will plunge the United States into more debt and hike borrowing costs for taxpayers. It could also—calamitously—create an unnecessary repeat of the 2008 financial crisis, one that is much worse because we are less prepared.

Which makes me feel like I need to state the obvious: Please pay your bills.