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The Great Global Freakout of 2011
Imagining the worst-case scenario if the United States even comes
close to defaulting on its debt.
By Annie Lowrey
Posted Thursday, April 21, 2011, at 6:00 PM ET

It will get ugly if we don't raise the debt ceiling
On July 6, 2011, a faint buzzing from your bedside table awakes you at
3 a.m. You ignore it. At 3:02, your Blackberry still vibrating, your
iPhone, which you use for personal email and calls, starts in with the
same high-frequency drone. At 3:03, your home phone starts ringing.

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You're a principal at a small, New York-based financial firm. The
sudden cacophony means the worst has happened. In mid-May, the United
States hit the debt ceiling: Because Congress failed to increase the
debt limit, the Treasury Department could no longer issue new bonds to
finance the United States' deficit spending and to pay the interest on
its existing debt. For a few weeks, Treasury and the White House were
able to move money from one pocket to another to keep the country
running smoothly. But the congressional bickering never abated, with
Republicans insisting on the passage of huge, immediate spending cuts
and a balanced budget amendment, and Democrats refusing to consider
either—and certainly not to tie them to the debate over the $14.3
trillion ceiling.
Uncertainty hit the bond market, though not as hard as some expected:
For a few weeks and for the most part, investors shrugged it off. But
as the intransigence got worse and investors became more spooked, they
started selling off Treasury bonds. Financial firms also quietly
started converting investments into cash, seeking the absolute and
unconditional safety that only dollars provide. The stock market
slumped.
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Weeks into the impasse, some Social Security payments stopped going
out, causing American citizens to scream bloody murder. They barely
noticed when, just before midnight on July 5, Treasury said it would
start missing scheduled coupon payments on some bonds. Wall Street
didn't miss the announcement, though—hence your 3 a.m. wakeup call.
The United States, to the shock and horror of investors around the
world, sat on the brink of default. The world's safest investment
became the world's most uncertain, tipping the markets into chaos.
You dash into your office and arrive by 5 a.m., finding a whole lot
more than the Tokyo traders hanging out. Dozens of panicked associates
are already there, flipping the TVs from CNBC and Bloomberg to C-SPAN
and CNN. Analysts are reading The Hill and Politico, trying to figure
out where the congressional negotiations, which lasted all night and
have dragged on for months, now sit. You take a look at some of your
company's positions, and reaffirm to yourself that you are in good
shape, at least on paper: solidly profitable, light on crummy assets,
and carrying a considerable cushion of cash and some foreign
currencies. But you receive the first of a few bad calls at 6 a.m.
Foreign investors are spooked, and they're dumping Treasury bonds—
billions of dollars' worth. They had been selling them off for weeks,
of course, possessing much less stomach for the idiocy of the U.S.
political system than you and your fellow Americans. But now,
investors in Asia and Europe are practically using tractors and
pitchforks to move the bonds onto the markets. You and your fellow
principals meet: Will the bond market finally force Congress to act?
Will this sell-off prove temporary? Should you buy what everyone else
is terrified of? Should you all be worrying about hunkering down and
battening the hatches and hoarding cigarettes for the barter economy?
You leave that issue aside for the moment. You know, from your
experiences in 2008, to keep a close eye on the $12-trillion "repo
market." You rely on it: Every night, your firm takes hundreds of
millions of dollars of low-risk securities and, in essence, swaps them
for cash on that market. That helps you maintain your balance sheet
and provides your trading partner with a bit of income. Now, repo
lenders are asking for more collateral for their cash, imposing a
"haircut" on Treasury debt and agency debt, such as the bonds issued
by Fannie Mae. The repo markets are again threatening to seize.
But by 9 a.m., you are onto other worries. Your firm had used
Treasurys to help finance a big investment in emerging markets. Given
the foreign sell-off, those Treasurys, once as close to cash as any
investment came, are now worth less. The other side of the deal wants
you to cough up actual cash to make up the difference. That means that
your firm will have to sell off some holdings into a very bearish
market in order to keep the investment. It is going to hurt your
bottom line. And you imagine similar calls happening across the
financial system.
At 10 a.m., you turn your attention to money-market funds—low-risk
investment pools that offer stable-value shares with small returns.
Such funds provide a lot of short-term liquidity for businesses. They
also hold a whole lot of short-term Treasury debt. You remember what
hell broke loose when such funds went on the fritz in 2008. Just one
fund "broke the buck," essentially repricing its dollar shares at 97
cents. That caused at a $500 billion run on all money-market funds. A
possibility predicted by J.P. Morgan analyst Terry Belton months
before, you hear a rumor that a big money-market fund carrying a lot
of Treasurys might have to break the buck this time too, and
frightened investors are pulling out and demanding their money back.
Within 72 hours, Congress has a deal on President Obama's desk,
raising the ceiling to $16 trillion in exchange for balanced budgets
to take effect in fiscal-year 2015 and some serious cuts now. Treasury
starts issuing new bonds and making all payments on existing ones. But
the market panic requires the Federal Reserve to reboot its emergency
programs, disrupts the housing market, permanently raises the United
States' borrowing costs, reshapes the world bond market, and shaves
more than a percentage point off GDP growth—enough to throw the
economy back into recession. Globally, investors no longer consider
the dollar the reserve currency of choice.
You wish you'd just never gotten up that morning