Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Overclockers UK Custom Built PC 1 YEAR Use Review Verdict - Does it Still Work? - 16th Oct 21
Altonville Mine Tours Maze at Alton Towers Scarefest 2021 - 16th Oct 21
How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
The Only way to Crush Inflation (not stocks) - 14th Oct 21
Why "Losses Are the Norm" in the Stock Market - 14th Oct 21
Sub Species Castle Maze at Alton Towers Scarefest 2021 - 14th Oct 21
Which Wallet is Best for Storing NFTs? - 14th Oct 21
Ailing UK Pound Has Global Effects - 14th Oct 21
How to Get 6 Years Life Out of Your Overclocked PC System, Optimum GPU, CPU and MB Performance - 13th Oct 21
The Demand Shock of 2022 - 12th Oct 21
4 Reasons Why NFTs Could Be The Future - 12th Oct 21
Crimex Silver: Murder Most Foul - 12th Oct 21
Bitcoin Rockets In Preparation For Liftoff To $100,000 - 12th Oct 21
INTEL Tech Stock to the MOON! INTC 2000 vs 2021 Market Bubble WARNING - 11th Oct 21
AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
Stock Market Wall of Worry Meets NFPs - 11th Oct 21
Stock Market Intermediate Correction Continues - 11th Oct 21
China / US Stock Markets Divergence - 10th Oct 21
Can US Save Taiwan From China? Taiwan Strait Naval Battle - PLA vs 7th Fleet War Game Simulation - 10th Oct 21
Gold Price Outlook: The Inflation Chasm Between Europe and the US - 10th Oct 21
US Real Estate ETFs React To Rising Housing Market Mortgage Interest Rates - 10th Oct 21
US China War over Taiwan Simulation 2021, Invasion Forecast - Who Will Win? - 9th Oct 21
When Will the Fed Taper? - 9th Oct 21
Dancing with Ghouls and Ghosts at Alton Towers Scarefest 2021 - 9th Oct 21
Stock Market FOMO Going into Crash Season - 8th Oct 21
Scan Computers - Custom Build PC 6 Months Later, Reliability, Issues, Quality of Tech Support Review - 8th Oct 21
Gold and Silver: Your Financial Main Battle Tanks - 8th Oct 21
How to handle the “Twin Crises” Evergrande and Debt Ceiling Threatening Stocks - 8th Oct 21
Why a Peak in US Home Prices May Be Approaching - 8th Oct 21
Alton Towers Scarefest is BACK! Post Pandemic Frights Begin, What it's Like to Enter Scarefest 2021 - 8th Oct 21
AJ Bell vs II Interactive Investor - Which Platform is Best for Buying US FAANG Stocks UK Investing - 7th Oct 21
Gold: Evergrande Investors' Savior - 7th Oct 21
Here's What Really Sets Interest Rates (Not Central Banks) - 7th Oct 21
CISCO 2020 Dot com Bubble Stock vs 2021 Bubble Tech Stocks Warning Analysis - 6th Oct 21
Precious Metals Complex Searching for a Bottom - 6th Oct 21
FB, AMZN, NFLX, GOOG, AAPL and FANG+ '5 Waves' Speaks Volumes - 6th Oct 21
Budgies Flying Ability 10 Weeks After wings Clipped, Flight Feathers Cut Grow Back - 6th Oct 21
Why Silver Price Could Crash by 20%! - 5th Oct 21
Will China's Crackdown Send Bitcoin's Price Tumbling? - 5th Oct 21
Natural Gas News: Europe Lacks Supply, So It Turns to Asia - 5th Oct 21
Stock Market Correction: One More Spark to Light the Fire? - 5th Oct 21
Fractal Design Meshify S2, Best PC Case Review, Build Quality, Airflow etc. - 5th Oct 21
Chasing Value with Five More Biotech Stocks for the Long-run - 4th Oct 21
Gold’s Century - While stocks dominated headlines, gold quietly performed - 4th Oct 21
NASDAQ Stock Market Head-n-Shoulders Warns Of Market Weakness – Critical Topping Pattern - 4th Oct 21
US Dollar on plan, attended by the Gold/Silver ratio - 4th Oct 21
Aptorum Group - APM - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 3rd Oct 21
US Close to Hitting the Debt Ceiling: Gold Doesn’t Care - 3rd Oct 21
Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
Original Oculus VR HeadSet Rift Dev Kit v1 Before Facebook Bought Oculus - 3rd Oct 21
Microsoft Stock Valuation 2021 vs 2000 Bubble - Buy Sell or Hold Invest Analysis - 1st Oct 21
How to profit off the Acquisition spree in Fintech Stocks - 1st Oct 21
�� Halloween 2021 TESCO Shopping Before the Next Big Panic Buying! �� - 1st Oct 2
The Guide to Building a Design Portfolio Online - 1st Oct 21
BioDelivery Sciences International - BDSI - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 30th Sep 21
America’s Revolving-Door Politics Behind the Fall of US-Sino Ties - 30th Sep 21
Dovish to Hawkish Fed: Sounds Bearish for Gold - 30th Sep 21
Stock Market Gauntlet to the Fed - 30th Sep 21
Should you include ESG investments in your portfolio? - 30th Sep 21
Takeda - TAK - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 29th Sep 21
Stock Market Wishing Away Inflation - 29th Sep 21
Why Workers Are NOT Returning to Work as Lockdown's End - Wage Slaves Rebellion - 29th Sep 21
UK Fuel PANIC! Fighting at the Petrol Pumps! As Lemmings Create a New Crisis - 29th Sep 21
Gold Could See Tapering as Soon as November! - 29th Sep 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

U.S. Debt Default or Credit Ratings Downgrade Could Crush the Global Economy

Economics / Global Debt Crisis Jul 29, 2011 - 06:13 AM GMT

By: Money_Morning

Economics

Best Financial Markets Analysis ArticleShah Gilani writes: If there's a "worst-case scenario" for this whole debt-ceiling debacle, this is it.

After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge - and economies around the world would crash.


Tangible evidence that this frightening scenario could really play out surfaced on Monday, when the Chicago Mercantile Exchange (CME) announced it was increasing the "haircut" that it applies to U.S. government debt posted as collateral by traders transacting on the exchange.

The retail investors who didn't just ignore this announcement altogether probably dismissed it as a boring bit of administrative housekeeping by the CME. In truth, however, this kind of re-evaluation of U.S. Treasury securities, widely used as loan collateral, could trigger global margin calls and widespread asset sales. If that occurs, it's only a matter of time before the ripple effects of escalating margin calls could weigh down asset prices around the world.

Let's take a look at how and why this could happen.

The "Haircut" Nobody Wants
Because U.S. Treasury bills, notes, and bonds are considered "risk-free" they are every lender's preferred collateral class.

All of America's too-big-to-fail banks, major securities broker-dealers and giant hedge funds - and most of the world's biggest financial institutions - hold hundreds of billions of dollars of U.S. Treasuries that they use as collateral to borrow in the overnight and term "repo" market.

Traders use their U.S. Treasury securities to borrow more money to buy still more Treasuries, as well as other more-speculative securities. The intention is to leverage the capital they have by borrowing against balance-sheet assets to take on bigger positions.

But what happens if there's no debt-ceiling deal by Tuesday - the theoretical day after which the country won't be able to pay its bills?

The actual answer to that question may not matter as much as the uncertainty that's been created. In fact, even with a deal - meaning there's no default - it's likely the United States is facing a reduction in its top-tier AAA credit rating.

.In the event of a U.S. default, a downgrade, or a combination of the two, the Frankenstein-like facelift that will change markets for years to come is going to start with a "haircut" that trims the collateral value of U.S. Treasury debt.

Lately, the word "haircut" has been transformed to mean a loss - as in "my stocks went down in the bear market ... man, I took a real haircut."

But that's not the technical definition.

A "haircut" is actually a securities-industry term that pertains to the U.S. Securities and Exchange Commission (SEC) Uniform Net Capital Rule 15c3-1. Securities broker-dealers, regulated by the SEC, have to maintain a minimum amount of "net capital" - or enough of a capital cushion to remain solvent.

When calculating their net capital, securities firms weigh their liabilities against their assets.

But not all assets are treated equally.

In some cases, such factors as credit risk, market risk and even its maturity can bring about an increase in uncertainty for certain assets. If that happens, the SEC can demand that firms "haircut" that asset - marking down its cash value using general formulas that discounts its "present value."

The more an asset has to be haircut, the less its collateral value becomes.

The Collateral Calamity
Because U.S. Treasuries are U.S. government obligations and have traditionally been considered to be essentially risk-free, they typically haven't had to suffer much in the way of haircuts.

In fact, short-term Treasury bills aren't haircut and the longest-dated Treasury securities are only haircut by 6%. For the most part, haircuts on government securities are based on weekly yield volatility measures calculated by the Federal Reserve Bank of New York.

But since traders have used those Treasury securities to borrow more money to buy more government bonds and other (more-speculative) investments, a bigger-than-normal haircut on federal debt obligations will cause lenders to demand additional security on the loans they've made to leveraged trading desks around the world.

Leverage is all fine and good, as long as one of the following two things don't happen to you.

The first thing that's bad news for leveraged trader is if prices fall. If you're leveraged enough, and the prices of the assets you're loaded up with start to decline, you can quickly start eating into your capital base.

For example, if you are leveraged 10-to-1, meaning you have $1 of capital and a $10 asset position, the price of your position only has to fall by 10% to completely wipe out your capital. In the current market environment, a 10% move in just about any asset class can happen in a day or two - if not in a matter of hours or minutes.

The second thing that wreaks havoc with leveraged trades is if the collateral that's been posted to borrow money (with which the leverage is accomplished) falls in value, then lenders will demand additional collateral, usually in the form of cash.

Of course, the double whammy occurs if the value of your collateral (in our present scenario, that means U.S. Treasury securities) falls at the same time that the securities you're leveraged up with (we're once again referring to U.S. Treasuries) also fall in value ... well, you're toast.

And the fallout won't end with you.

The Ultimate Debt-Ceiling Debacle
This could actually result in a kind of "global margin call" - kicking off a worldwide de-leveraging scenario that could sink global markets and torpedo world economies. That's the Frankenstein-like facelift I referred to earlier.

Here's why.

The credit-ratings downgrade and an outright default play a big role in this, too. You see, while a ratings downgrade would affect America's perceived credit quality, an actual default would change the market's fundamental consideration of cashflow rights and the degree of certainty held about future payments regarding government obligations. Such a radical change in the quality and market-risk features of government securities would mean that they would be subject to deeper haircuts.

There's the debt-ceiling-debacle "trigger" I've been talking about.

As leveraged institutions have to take deeper haircuts on the Treasuries they've put up as collateral for their loans, they'll have to come up with additional collateral. If at the same time they are required to post additional collateral their leveraged positions are being marked down, there's likely to be a sell-off of multiple asset classes as cash has to be raised.

Default is a game-changer.

Government securities will no longer be pure-interest-rate instruments. They will immediately assume the risk profile and characteristics of lesser-credit products and not be the baseline against which all other credits are measured, but demand new measures of their own default probabilities.

It's bad enough that the U.S. government securities market is the largest securities market in the world. What's even worse is that the derivatives market - which is at least 100 times as large as the U.S. government securities market - principally uses Treasury securities as collateral for their "private contracts."

If you don't think this is a real scenario, think again: Monday's move by the CME shows that it's already started.

It's only a matter of time before the effects of building margin calls weigh on asset classes around the globe.

To be forewarned is to be forearmed: Let's just hope that Washington resolves this whole debt-ceiling debacle before this global-margin-call cycle gets started.

[Editor's Note: If there's a lesson for us to learn from the past five years, it's this: A shrewd, fast-moving and greedy Wall Street is going to outfox an indentured, corrupted and gridlocked Washington ... every time.

As an investor, the only way you're going to survive such a stacked-deck environment is to have the kind of top-shelf investing insights and intelligence that the investing masses don't have.

That's what we bring you.

We bring it to you each day in Money Morning. We not only give you the news, we tell you what that news means and show you how to turn it to your investing advantage.

But you need more.

You need to see how that news feeds into the longer-term trends that control global money flows, for that's where the real money is made. That's why successful investors also read our affiliated newsletter The Money Map Report.

MMR gets behind the stories and looks at the trends and powerful global money flows that are creating some of the best investing opportunities of our lifetimes. Those trends - as well as some great protection tips - will leave you better-informed, safer and wealthier than you've ever been.

Successful investors read The Money Map Report.

Please click here and take a minute to check out our latest offer.]

Source :http://moneymorning.com/2011/07/29/...

Money Morning/The Money Map Report

©2011 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in