08/01/2011 08:31 am ET Updated Oct 01, 2011

Default or No, Real Economics Ahead

The debt deal President Obama announced last night goes to Congress Monday, where a handful of fanatics are waiting for it. The question is whether they'll choose the Samson option.

But it doesn't matter whether America defaults on our national debt. The damage is done. The world's seen we're barely able to govern ourselves, and our economy will pay the price. The only question: How bad it will be.

Just talking about a possible default has triggered likely credit downgrades of US Treasury debt that will drive up the cost of money worldwide, slow the global economy, and also, for us, raise unemployment -- and the deficit; JP Morgan Chase & Co. says a credit downgrade could cost the federal government an extra $100 billion in debt payments.

But Neil Kashkari, who headed the original TARP program, thinks fallout from a downgrade could be worse -- a possible global meltdown, bigger than anything we saw in 2008-2009.

This, when our economy is already more or less dead in the water. According to revised statistics from the federal Bureau of Economic Analysis (BEA), the recession was worse than previously thought, and the "recovery" was less than complete -- the BEA says the economy fell 5.1 percent during the recession -- the original estimate was 4.1 percent -- and grew 5.0 percent during the "recovery".

That news is unwelcome, at best, since much of the world is no better off than we are. In the Eurozone, for instance, Italy and Spain are expected to join Greece in default. Japan, which has been in a slump since its early 1990s crash, will be working through the damage from the tsunami-triggered nuclear disaster at Fukushima for some years yet. And many economists think China's economy is heading for a hard landing.

Global debt markets are already pricing the possibility of a US default into the price of money; stock indices fell last week, while the Dollar declined against most major currencies. Less prominent indicators watched by financial professionals, like the cost of repos, or repurchase agreements, likewise showed signs the economy is in an ugly mood

China's Da Gong Global Credit Rating Co. already grades our credit as AA, with a negative outlook.. And Standard & Poor's and Moody's both say merely raising the debt ceiling won't preserve our AAA rating in their books, because that doesn't solve our long-term fiscal problems.

Since all bonds are priced off Treasuries, and the $14 trillion Treasuries market is the world's largest asset class, lower credit ratings mean higher borrowing costs worldwide. Higher borrowing costs in turn drive up the cost of doing business and both cut profits, and raise prices.

The likely result will be the worst of all possible worlds -- an inflationary recession. Since this already describes life in a country where many ordinary Americans can now barely afford hamburger, lowering America's debt rating will only worsen matters -- if nothing bad happens.

And if something bad does happen -- some sort of break in the securities markets, say, triggered by ongoing trench warfare in Washington -- we can expect what former Treasury Secretary Larry Summers, discussing the fallout from a default, called "Lehman Brothers on steroids".

What that could cost is laid out in horrible detail in a Government Accountability Office (GAO) study of the Federal Reserve's operations during the '08-'09 Crash, released July 21st.

Remember that horrible $800 billion in TARP money? According to the GAO study, the real price tag for propping up America's financial markets was $16.115 Trillion. It's unlikely that straightening out a more severe crisis will cost less.

You can read the report, including a detailed explanation of specifics, here. You'll find a report of all the amounts broken out on page 144, and a list of all the institutions that borrowed money -- and how much -- on page 131.

The study makes for interesting reading. To give some idea of how close we were to financial disaster after the collapse of Lehman Brothers: Four US banks -- CitiGroup, Morgan Stanley, Merrill Lynch, and Bank of America, account for almost half the total outlay -- $7.847 trillion. Bank of America and Merrill Lynch, which were merged by the Fed during the crisis, account for $3.292 trillion of that amount.

Two notes: The foreign banks on the list on page 131 are all US branch networks of said banks that had significant US operations; a collapse there could have triggered a wave of other problems at a time the stability of the global financial system hung in the balance. And a data base of what the list calls "other borrowers", including hedge funds, can be found here.

It's worth mentioning that all the money's been repaid, aside from $909 billion in mortgage-backed securities issued by Fannie Mae and Freddy Mac -- they're still paying interest -- and money set aside to unwind outstanding credit default swaps issued by AIG, listed under three entities, Maiden Lane I, II, and III. The New York Fed is on Maiden Lane in downtown Manhattan.

This report should be studied by anyone who thinks -- as certain right wingers still insist -- that a US default would not be such a big deal.

History aside, the longer-term economic trend for us is down, even if there's no market break, because of the effect of higher Treasury yields on the most important market you never heard of -- the repo market.

The market in repos, or repurchase agreements, is usually estimated to be $11 trillion a day, according to Mary Fricker, editor of the website Repo Watch. Repos are used as collateral for all the world's securities and currency trades.

Mostly US Treasury or agency debt, repos can also be British or German government debt, cash, or some AAA corporate bonds. They're essentially rented to the buyer in a securities or currency deal, which puts them up as collateral to guarantee payment when it closes. For legal reasons, the collateral is sold to the buyer, and the renter promises to repurchase it when the deal closes -- hence the term repo.

In those deals, the buyer puts up 100 percent of the value of the transaction in repos, and pays one day's interest on the collateral, plus another fee on top of that called a "haircut" -- typically an extra two percent of the total transaction.

If US debt is downgraded, explains Gary B. Gorton, a Yale professor who often writes on the subject., the seller will likely demand more collateral to secure the deal -- probably, he expects, another one percent of the deal's value, which doesn't sound like much until you realize that a typical currency deal is rarely less than $1 billion in a market that usually totals about $2.5 trillion a day

"Those higher fees and yields will be like throwing sand in the gears [of the world economy]," says Prof. Gorton, who is Yale's Frederick Frank Class of 1954 Professor of Management and Finance, because that extra one percent will eat into the deal's profits, in turn cutting a company's earnings.

Mary Fricker thinks there's another reason to think repos could figure in a potential downturn: Even in an $11 trillion market, she says, there are only so many repos, and in the flood of sell orders during the 2008 market break, a shortage of available repos created a bottleneck in the securities markets, because trades had to wait their turn for collateral. Meanwhile, the market was falling, magnifying losses.

And unfortunately for us, the underlying math that triggered the late Crash -- an algorithm called VaR, or Value at Risk -- is still driving trading platforms across the world, embedded in its very warp and woof.

When the market for very arcane derivatives called synthetic collateralized debt obligations suddenly froze in the fall of 2007, VaR flashed sell signals in trading rooms everywhere, creating a rush to the exits, and a pile of bodies at the doors.

But compared with the entire world's bond market, the collateralized debt obligation market was tiny -- a few hundred billion dollars. The value of the global bond market, on the other hand, was an estimated $82.2 trillion in 2009. And interest rates for those bonds are entirely based on some risk premium over US Treasuries.

Thus, a downgrade of America's credit rating means that the entire bond market will be re-priced to reflect the change -- every bond, everywhere, all factored into VaR's calculations.

Because of that, there's little reason to think that a sudden shift in Treasury yields and prices worldwide will have no effect on the calculations that VaR makes about whether to buy or sell. And assuming it does advise traders to sell, there will very likely be a flood of said orders that will dwarf anything seen in 2008, if only because so much more value is affected.

You can guess the rest.

Against this background, we have Paul Teller, executive director of the Republican Study Committee -- a coordinating group for right wing Congressmembers -- emailing his membership the week of July 18th that "I'm now more confident than ever that a final solution [to the debt negotiations] cannot come before, say, August 4th or 5th. We MUST get past August 2nd [the day the US would default] if we conservatives are to win."

Now the debt deal's announced, the nation will wait to see how many Republicans in Congress follow Mr. Teller's advice.

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