By LOUISE STORY and JULIE CRESWELL
Published: July 20, 2011
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.
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Jeff Swensen for The New York Times
Deborah Cunningham oversees $271 billion in money market funds at Federated Investors in Pittsburgh. She created plans several weeks ago for dealing with a federal default.
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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 .