What bankers are saying about the debt limit

While the federal government partial shutdown continues into a second week with no deal in site, many are turning their attention to the looming debt crisis. If Congress doesn’t agree to extend the debt ceiling, or the amount the government can borrow, by mid-October then the U.S. may plunge the entire global economy into the dumps.

The Wall Street Journal had a story Monday saying that top bankers were warning about a potential plan to pay bond interest might backfire:

Top Wall Street executives are warning that any effort to pay interest on U.S. debt before other obligations such as Social Security, a strategy some lawmakers think would placate bond investors if the government breaches its borrowing limit, would pose severe risks to financial markets and the economy.

In recent meetings with Republican lawmakers and Obama administration officials, chief executives of the nation’s largest financial institutions said putting some payments ahead of others would create insurmountable uncertainty for investors, drive up borrowing costs and cause market disruptions, according to people familiar with the meetings.

The Wall Street pushback against an idea backed by the House GOP is part of an effort to force a resolution on raising the nation’s borrowing limit, which the Treasury has said it expects to reach by mid-October. If no deal is reached, many outside observers, including debt-ratings firms, assume the government would begin prioritizing payments to bondholders over others, such as Social Security recipients or veterans, rather than risk defaulting on U.S. debt.

Market participants say while the U.S. might not technically default on its debt, missing any type of payment would likely harm the economy. “This is going to be permanently damaging for business and consumer confidence if this happens. People will never look at the United States Treasury the same ever again,” said Tom Simons, money-market economist at Jefferies Group LLC, an investment bank.

The fast-approaching deadline, paired with the inability of Republicans and Democrats to make headway in resolving it, is starting to ripple through global markets that until recently had appeared blasé.

Stocks fell Monday, with the Dow Jones Industrial Average down 136.34 points, or 0.9%, to 14936.24. U.S. Treasury notes, seen as a haven in times of volatility, rose, as did the price of gold. The Chicago Board Options Exchange’s Volatility Index, a gauge of fear in the stock market, rose 15%.

The New York Times wrote a piece saying that Wall Street continued to brush off fears that the government would actually default:

Wall Street is showing few signs so far that it is fearing the financial panic it has been predicting should the government default on its debt.

The fiscal impasse in Washington continued to weigh on stock prices on Monday, as the market’s “fear gauge,” the C.B.O.E. volatility index, jumped 15.95 percent to its highest level since June. Nonetheless, the market reaction to date has been muted compared with past crises.

“We all tell ourselves, ‘This is something that is not going to happen,’ ” said David Coard, the head of fixed-income trading at the Williams Capital Group. “This would be like a black swan event — it’s not something that you would have thought that the U.S. could do in a million years.”

But the relative calm on Wall Street is worrying some investors, who fear the markets will not signal to politicians the true danger of hitting the debt ceiling until it is too late.

“The markets are sending this complacent message, and I think the politicians are interpreting it incorrectly and they have no sense of urgency,” said Douglas Kass, the owner of the hedge fund firm Seabreeze Partners Management.

There are certainly signs that nervousness on trading desks is growing as the nation draws closer to Oct. 17, when the Treasury Department has said it will run out of emergency measures to borrow more money. Soon afterward, the government could run out of money to make payments on its bonds — the much-dreaded default that has Washington buzzing.

But the NYT’s Dealbook editor, Andrew Ross Sorkin, wrote a column claiming that a default is possible:

“The United States government is not going to default, ever.”

That’s what Vincent Reinhart, former head of the Federal Reserve’s monetary division and now managing director and chief United States economist for Morgan Stanley, said late last week.

“As political theater,” he said, “the debt ceiling is not a useful threat, because politicians are basically threatening to shoot themselves, as they will rightly shoulder the blame for the serious global economic consequences of a default.”

Mr. Reinhart’s view has become conventional wisdom on Wall Street when it comes to whether the country will hit the debt ceiling limit on Oct. 17. Warren Buffett put it this way: “We’ll go right up to the point of extreme idiocy, but we won’t cross it.”

Nobody believes the country will actually exceed the debt limit — which is exactly why it might.

Oddly enough, despite all the predictions of panic, the stock market was down only marginally over the last couple of sessions.

Here’s the perversity of Wall Street’s psychology: The more Wall Street is convinced that Washington will act rationally and raise the debt ceiling, most likely at the 11th hour, the less pressure there will be on lawmakers to reach an agreement. That will make it more likely a deal isn’t reached.

That just can’t be good. Since the markets aren’t reacting to the potential default, the conventional wisdom is that it may give politicians a false sense of security. And if that’s the case, we’re all in trouble. Let’s hope someone blinks first.