Though it may have to wait another quarter to be relevant given the news of a possible 3-month extension of the debt ceiling, we continue to quote from commentary on the topic. (Nothing is official yet, but but see Reuters' "Traders see U.S. debt ceiling risks shift to December".) Wells Fargo Money Market Funds' latest Portfolio Manager Commentary, entitled, "Frequently asked questions: The debt ceiling discusses the issue in depth. Its "Debt-ceiling FAQ," explains, "While we have faced a debt-ceiling crisis many times since the onslaught of the financial crisis -- six to be exact -- this time around seems especially urgent for two specific and intertwined reasons: the coincidence of the U.S. budget's fiscal year-end and the Treasury hitting the debt ceiling after exhausting extraordinary measures and legislative and executive branches of government that can't seem to play nicely with each other, let alone amongst themselves!"
They tell us, "Any discussion should be prefaced by our belief that the likelihood of one or multiple technical defaults due to a protracted debt-ceiling debate is remote; that in the unlikely event there should be a technical default, it will be short lived; and that upon resolution, investors and funds are likely to be unaffected. We further believe that, given evidence of preplanning, the Federal Reserve (Fed) would be prepared to step into the markets in order to calm them and ensure smooth and orderly functioning of the government markets.... In terms of current events, past experience shows us that when push comes to shove, legislators will raise the debt ceiling in order to avoid a default."
Wells asks, "What impact, if any, does a prolonged debate on raising the limit have on the money markets? Prior to the debt-ceiling-suspension era, the money markets reacted to the debt ceiling once per episode -- when the debt outstanding approached the limit, cash approached zero, and extraordinary measures approached exhaustion. Leading up to that time, the Treasury typically reduced Treasury bill (T-bill) issuance, resulting in a relative shortage of T-bills, driving their yields lower. At the same time, as the market assessed the likelihood of nonpayment on particular Treasury securities, those instruments generally sold off. The specific securities deemed at risk were generally T-bills maturing in the several weeks after the drop-dead date, as well as Treasury notes and bonds, both those maturing in the same time period and those with interest payments due in that window."
They state, "The rates on other money market instruments, including government-sponsored enterprise (GSE) discount notes, were generally little changed, as they would be unaffected by a payment delay on Treasury securities. As a result, at least in the threatened maturity window, GSE securities were considered to be of higher credit quality and often traded through similar-maturity Treasuries at lower yields. When Congress changed its approach to raising the debt limit in 2013 by suspending it until a future date rather than merely raising it to a certain amount, it complicated and extended the impact on the money markets."
Wells' Q&A comments, "The money markets now react twice to a debt-ceiling episode, once as the Treasury reduces T-bill issuance to run its cash balance down as the end of the debt-ceiling suspension period approaches and then again months later as the real binding deadline, the drop-dead date, nears. The early reaction phase is due solely to the decline in T-bill supply, with none of the default concerns present, as extraordinary measures have not even begun to be used. This early T-bill drawdown was caused by the practice of suspending the debt limit and was magnified by the Treasury's large cash balance.... The later market reaction phase, as the drop-dead date approaches, includes the angst that accompanies flirtation with default and is similar to episodes before Congress changed its approach to include a debt-ceiling suspension."
It says, "If we get to the point that the Treasury has exhausted all extraordinary measures, explored any further measures, and simply run out of cash to pay the government's bills, then it is likely it would have to default. But what is meant by "default"? The most likely answer is that it would mean a temporary delay in payments that come due -- in this case, the payment of maturities and interest on Treasury securities. This is widely termed a technical default.... So, the bottom line is that we have no reason to expect the government will default on its obligations in the sense we traditionally know. The worst-case scenario is that it may have to delay a payment or two for a very short period of time, but the payment likely will be made."
Wells update asks, "What would happen to defaulted Treasury securities? Would they be transferable? The transcripts of the Fed's 2011 debt-ceiling conference call show widespread support for Fed operations treating "defaulted Treasury securities in the same manner as nondefaulted securities ..." for purposes of "... outright purchases, rollovers, securities lending, repos, and discount window lending." This treatment would be the case so long as the default reflected a political impasse and not any underlying inability of the U.S. to pay, with the understanding that it reflected only a short delay in payment."
Regarding Repos, they tell us, "From an operational standpoint, defaulted Treasury securities, the specific issues that had suffered missed or delayed payments, would still be eligible for inclusion as collateral in repo transactions so long as they remained in Fedwire, the Treasury transaction settlement system. As a practical matter, lenders might be reluctant to accept such tainted securities as collateral unless higher haircuts, or margins, were offered. In addition, it's possible that lenders also could refuse to accept Treasury securities at risk of default as collateral, even if the Treasury had not yet missed a payment on any security. Because there is no cross-default provision for Treasury securities the vast majority of Treasury securities could continue to be used to collateralize repo transactions, at least operationally."
It adds, "While the plumbing of the repo market thus likely would be unimpaired by a default and remain functional, the outlook for repo market conditions is less certain. A U.S. government default, even a temporary, technical one, could be highly destabilizing for the broader financial markets. Normal cash lenders in the repo market could well decide to remain more liquid than usual, preferring either to leave cash uninvested or to place it in the Fed's reverse repo program, which would provide the added layer of security that comes from having the Fed as the counterparty. With market participants faced with vast uncertainty, repo market rates could move substantially higher."
They also ask, "How would a default affect the Wells Fargo Money Market Funds? We believe any impact of a payment delay would have a minimal and transitory effect on the Wells Fargo government, Treasury, and Treasury-plus funds (collectively, the government funds). For some time now, the government funds have been managed with a focus on liquidity and principal preservation. Our funds' current liquidity levels exceed the minimum U.S. Securities and Exchange Commission (SEC) required levels, and we believe the funds' maturity structure should help minimize the effects of any short-term price volatility that may be caused by these potential credit events. The funds also could seek to increase liquidity by increasing cash balances, should it become necessary."
Wells continues, "It is unlikely any type of payment delay by the Treasury will affect our funds investing primarily in corporate and municipal obligations. Our past experience with these markets in times of debt-ceiling crises has been that they continue to function as usual; with a relatively smaller allocation to these types of assets in the post-reform environment, any asset pressures should be relatively more muted than in the past. As of the time of this writing, none of the Wells Fargo prime or municipal money market funds hold Treasury securities."
They also ask, "If the U.S. government were to default, would money market funds be required to sell defaulted securities? Not necessarily. Under SEC Rule 2a-7, a fund is not automatically required to dispose of a security that is in default. A fund may continue to hold a defaulted security if the fund's board of trustees deems it would be in the best interest of the fund's shareholders. For example, such a decision may be made under a hypothetical scenario in which a fund's board believes any payment delay would be imminently resolved and an affected fund would receive its full maturity principal and interest; under these circumstances, a board may find it is not in the best interests of the fund or its shareholders to sell a delayed security, especially if such a forced sale would lead to a trading loss for the fund and adversely affect the net asset value (NAV)."
The Wells piece concludes, "With the end of September less than a month away, and the relative silence in the news cycle over this current event, it's not always easy to remember that the rate on which the Treasury will run out of money is still an unknown. At the last update, Treasury Secretary Mnuchin estimated it would be September 30. His bias, though, is to try and get the limit raised prior to the actual date it will run out of money; Street estimates, on the other hand, fairly consistently place the actual hard deadline in the beginning to middle of October. So, where the deadline will actually fall still remains to be seen, though as we progress through the month, we are likely to gain more clarity."
It adds, "In the meantime, it is not out of the realm of possibility, given the current political climate, that we will experience high drama around this exercise and that market volatility could increase as a result. This is a situation about which we are acutely aware and constantly monitoring, and we are managing the funds with the goal of minimizing volatility and preserving principal while maintaining liquidity for our shareholders. One thing is for sure: As long as a debt ceiling exists, we are likely to revisit this scenario at some future date!"
