How to think about the US debt battle

Mr Geithner is doing his best to reassure markets

Deep breath. Now repeat after me: the US government is not going to default on its debt.

If you don't believe me, ask Tim Geithner. He would say the same thing - if he could be sure that no Republican was listening.

That doesn't mean there's nothing to worry about, looking at the sorry saga unfolding in Washington this week. You just need to worry about the right things.

Both sides have an interest in talking up the risk of a formal default. Especially the treasury department - because it's Mr Geithner who will have to decide which bills to pay if it hits the debt limit without a deal with Congress.

But, as I pointed out a few weeks ago, the federal government will still have tax revenues flowing in after 2 August, even if Congress drops the ball - about $172bn (£105bn)-worth over the course of the month.

Mr Geithner only needs to use $29bn of that to meet the debt interest payment that is due on 15 August. Trust me, he will.

Maturing debt

Debt interest payments are only part of the story. To prevent a default, the federal government also needs to cover the principal on maturing treasury bills and long term government securities. The Bipartisan Policy centre estimates that $90bn will come up to maturity on 4 August, with another $90bn coming due on 11 August.

This, incidentally, is a vivid reminder of the different debt management practices of the UK and the US. Because the average maturity of US debt is so low, around $500bn of it comes up for maturity in August alone.

IMF figures show that America has to refinance the equivalent of 18% of GDP this year due to maturing debt (and that number does not include short-term treasury bills.) The figure for the UK is less than 7% of GDP.

There's $30bn in treasury bills coming due on 4 August. The ratings agency Fitch has said that it would not necessarily place the US sovereign rating into default if those bills were not repaid in full on that date - as long as there was a strong expectation that the money, and accrued interest, would be paid before the next lot of treasury bills matured, on 11 August.

They would, however, downgrade that particular issue from AAA to B+ the moment the payment date was missed.

So, in theory, the issue of a downgrade could come up long before that big interest payment on 15 August. But there is nothing to prevent the treasury from doing what it would usually do when these notes mature: pay back the holders by issuing new ones.

'Damage perceptions'

Now, Secretary Geithner has told Congress he doesn't want to prioritise debt payments. He has also said the ratings agencies might consider the US to be in default if it failed to meet any of its obligations - not just the obligation to service its debt.

Finally, he suggested that there might be a shortage of buyers for new securities, if there were no debt ceiling in place.

This is what you would expect him to say. He wants a deal.

However, there is no obvious legal barrier to the US putting debt service before other obligations. And Fitch has explicitly rejected his second argument, saying that non-payment of suppliers or delays in paying benefits "would damage perceptions of US sovereign creditworthiness, but would not itself constitute an event of default from Fitch's sovereign rating perspective."

Put it another way: the ratings agencies don't really care whether grandma gets her social security cheque. They only care what happens to her treasury bonds.

Would investors sit out treasury auctions after 2 August 2 if no debt limit is agreed? Perhaps. But I wouldn't say it was the most likely outcome.

Additional collateral

So, even with no debt limit agreement well into August, a US sovereign default could be easily avoided and it almost certainly would be. It is also perfectly possible that the US could hang on to its AAA credit rating.

But, unlike a formal default, such a downgrade is clearly possible. Indeed, for Standard & Poor's, it's a near certainty, if Congress and the president fail to agree a major debt reduction package (with savings of $3 trillion or more over 10 years).

Would this be the end of the world? Well, it would be a brave new one. It could also be extremely messy - for example, if it raised questions about the treasury securities and US agency debt that are used as collateral in the $3 trillion US repo market, forcing financial institutions to post tens of billions of dollars in additional collateral.

But even then, there's room to doubt whether the implications would be so cataclysmic. If US debt were to go from AAA to AA, most analysts - for example, JP Morgan Chase - seem to think the extra haircuts would be inconvenient, but not much more than that.

Nervous markets

All this might sound hopelessly complacent. As we learned in the case of Lehmans, there's a lot we don't know about the intricate web of financial transactions that binds the global financial system together. The implications could be much worse than we think.

But here's a thought experiment for you. Assume that under existing rules for posting collateral (or, say, allocating institutional investments) the US moving from AAA to AA turns out to pose a major threat to US financial institutions. Which do you think is more likely to happen in those circumstances: the end of the world, or a change in the rules?

To be clear: a world in which the world's largest debtor does not have the top credit rating is not one anyone should welcome. No-one can be sure what the implications would be if the deepest "safe haven" market was no longer considered top notch. And clearly, this is a bad time to be launching experiments.

But precisely because this is such a nervous time for world markets, you have to ask where, exactly, all the buyers of US treasury bonds will actually go?

They can't all buy Swiss francs. For all the worries about global sovereign debt, this is still a sellers' market. That is why the yield on US 10-year debt is still barely 3%.

You might see that rate go up if the US politicians continue to make a mess of things, and the markets might be in for a few bumps. But, for better or worse, America is still in a class of its own. When it comes to the definition of safe government debt, it gets to re-write the rules.