Treasuries lose risk-free status as collateral at CME

A sovereign nation that issues debt in its own fiat currency cannot default involuntarily. Again, [a default because of the debt ceiling] is the Ecuador risk factor, defaulting for purely political reasons, not because of the inability to pay. It is not clear whether there will be a risk premium associated with this risk, increasing the yield of Treasury bonds, as the showdown draws near. We saw this in Russia when the Rouble crisis hit in 1998…

For now, the ratings agencies are relatively sanguine about this dust-up. But, the risk of default is real – and that doesn’t sound like the hallmarks of a AAA-rated country, more like the hallmarks of a banana republic.

Debt Ceiling Showdown Coming, April 2011

There is now a risk premium associated with this risk factor. The Chicago Mercantile Exchange has now instituted a policy whereby formerly risk-free T-bills will be subject to a haircut of 0.5 percent starting this Thursday (hat tip Business Insider). The press release is embedded below. Moreover, it is likely that the US will lose its AAA status when it is downgraded by Standard & Poor’s.

What S&P’s action would mean for the cost of borrowing is unclear (UPDATE 1600ET: A Reuters report says this would cost $100 billion). What is clear is that the CME action will increase borrowing costs throughout the economy by making Treasuries more expensive to use as collateral for the borrowing that banks do in the ordinary course of business. This is directly attributable to the debt ceiling standoff. As the standoff continues, expect these costs to mount.

It bears noting that the debt ceiling showdown is proceeding largely as I indicated it might in the post quoted at the outset. At that time, I said that the tactical positioning for the Republican-controlled house was to draft legislation as near the debt ceiling deadline as possible so as to permit as little time as possible for Senate Democrats or President Obama to counter their legislation. The goal of Republicans is to put the onus (of rejecting the Republicans’ draft legislation) on Reid and Obama and take some of the heat off of themselves. However, the Senate can amend this proposal and can draft its own legislation which Harry Reid, the Senate Majority Leader has already done.

I don’t expect this to lead to default. The problem is what I identified in the April post:

House Speaker John Boehner does not want brinkmanship on this issue because he fears the repercussions of a default. But he is under pressure from colleagues to make a tougher deal, just as he was in the government shutdown fight

Some House Republicans don’t trust Boehner to negotiate a deal they want and are revolting over his proposed legislation. So the risk of default is indeed mounting.

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