America Tests its Financial Fate

On this Treasury Secretary Janet Yellen and JPMorgan CEO Jamie Dimon agree: A US government default on its debt obligations would be potentially catastrophic. Dimon said even getting too close to the brink could create a financial panic.

“People get the joke that’s going on in Washington,” says Jim Millstein, who served as the restructuring chief at the Treasury Department in the wake of 2008 financial crisis. “The strongest economy in the world, the most powerful nation in the world, is not going to pay its debts when due? You’ve got to be kidding.”

And yet we’re already seeing distortion in the markets. Beth Hammack, the co-head of the global financing group at Goldman Sachs, is the outgoing chair of a prominent committee of Wall Street executives that advises the Treasury Department. In a Bloomberg Television interview this week, she said:

You’re finding that investors are preferring to have securities that are going to mature toward the end of May, rather than anything that matures in June. So you get these dislocations, which are really just inefficient in the markets and create extra costs for the taxpayers. Taxpayers are paying a higher rate for issuing one-month bills now than they really should have to because of this.

Were the US to default and the Treasury stops making payments, Hammack says there would be a “huge ripple effect for the economy”:

That’s money that’s not ending up in consumers’ pockets, it’s not showing up in businesses, there’ll be government-sponsored enterprises that may not be receiving what they need, there may be public-sector municipalities or housing centers, hospitals, who are waiting on disbursements that are not getting them.

Let’s go through more consequences, some of which are true even if the US doesn’t default, but faces a downgrade from bond rating companies.

There’s been an historic move into money-market funds in the past couple of years, because they provided a higher return than most big bank savings accounts. Those funds are backed by Treasuries, and should the US be downgraded, “money-market funds themselves may have to cough out securities that are not rated what they told their investors they would be rated,” said Millstein, now co-chairman of Guggenheim Securities, in a Bloomberg Television interview.

Millstein also points to the $50 trillion capital markets—debt and equity—and particularly any hiccups in repo markets that could take those markets off course. That’s the overnight lending through banks and financial markets using Treasuries as primary collateral. “There will be a huge contraction of credit in the capital markets, in the liquidity that greases the skids in those markets, as well as a huge liquidity call,” he says. What’s more, corporations with AAA credit ratings can’t be rated more safe than the country they’re hosted in, meaning corporations could face downgrades and higher borrowing costs.

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Banking Troubles

In about three weeks, PacWest Bancorp’s stock has dropped by almost 60%. Just this week it disclosed a further drop in deposits given the market’s worries about the bank’s health. (These worries have largely been stock investor concerns rather than actual severe damage to its balance sheet.)

By the end of Thursday, PacWest was trading at a mere 20% of its book value, showing that investors don’t think it’s worth as much as the stated value of its assets. By comparison, the worst three performers in the KBW Bank Index are all trading at closer to 60% of their book value or better.

Investors are clearly on edge about the banking system, with even Bank of America trading below 90% of its book value, a rarity for such a big and highly regulated firm. Only two stocks in the KBW Bank Index are up on the year.

Some highlights from this week:

• Big banks are set to face billions in extra FDIC fees, a move that Jefferies analysts think will shave about 2.5% off earnings on average for a group of lenders.
• There has been a huge debate around short-selling bans (or at least more disclosures) to prevent investors from unfairly capitalizing off of struggling banks.
• Schwab, which is boosting its exposure to derivatives to hedge interest rate risk, expects emergency funding measures to start tapering but remain in limited amounts into 2025.
• A hedge fund trade with a history of blow ups is back again -- something to watch as bond traders look to profit in a highly-levered strategy off Treasury dislocations.

Who’s News

Josh Harris, the co-founder of Apollo Global Management who left the private asset giant in recent years, sold more than $100 million worth of Apollo stock as he nears a deal to buy the NFL’s Washington Commanders as part of a consortium. Over at Citadel Securities, Peng Zhao has a colorful story, as written by Bloomberg’s Katherine Doherty for Bloomberg Businessweek, about how he rose to the top of a hugely profitable empire for billionaire Ken Griffin. Vanguard’s Josh Barrickman made more money than almost any of his rivals in an historic bond rally. At BlackRock, leaders are placed into new roles, particularly in the alternatives business that had been run by Edwin Conway.

Hoping you have a great weekend. Next week, I'll be interviewing at SALT iConnections New York, where we'll be speaking with everyone from Marc Lasry on the state of distress and a range of quant giants on the next frontier for machine learning in finance. Tips & opinions are welcome in the meantime at [email protected].