JP Morgan: Repos will transmit the shockwave of a U.S. default

Money market funds, repos and foreign investors will transmit the shockwave of a U.S. default throughout the economy and the government, according to a JP Morgan report.

The authors of the report said they think a default is highly unlikely. But if it comes, Katy bar the door.

From the April 19 report:

Although we view a default as extremely unlikely, assessing these tail risks is an important part of risk management and is useful in understanding how markets might behave in the period leading up to a potential Treasury default.

Our analysis suggests that any delay in making a coupon or principal payment by the Treasury—even for a very short period of time—would almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the US economy.

These effects would be transmitted through three primary channels: US money funds, the Treasury repo market, and the foreign investor community, which holds nearly half of all Treasury securities.

The report described how the effects of a U.S. default could ripple out through the three channels.  It said frightened investors could take their money out of government money market funds, similar to the run on money market funds in 2008. It said repo lenders could demand more collateral, which could trigger damaging fire sales of securities and a tightening of credit, as in 2008. It said foreign investors could become less willing to buy Treasuries, which could lead to higher borrowing costs for the U.S. and bigger deficits.

The JP Morgan analysts estimate that $3.9 trillion in U.S. Treasuries – nearly half of the outstanding stock – are used as collateral for repo loans, based on the activity of the largest dealers. In the event of a U.S. default, U.S. Treasuries will fall in value. Repo lenders will demand more collateral – which in financial jargon is called raising the haircut – or they will refuse to renew the loan at all. That will force borrowers to sell Treasuries to raise money to repay repo debt. That will further drive down the value of the Treasuries.

Financial  wizards call this repayment of loans, this reduction of debt, deleveraging. Although repo borrowers are not as deeply in debt as they were in 2007 and 2008, they will still be damaged by this loss of credit, as will the financial markets in general, the report said.

From the JP Morgan report:

Although leverage among market participants is considerably lower than in 2008, we would still expect to see some forced deleveraging as a result of increased haircuts.

For example, REITs, which finance their mortgage-backed security purchases with repo, would likely need to delever; their selling of mortgage-backed securities would likely push mortgage rates higher, potentially inducing others to sell. In addition, we think relative value hedge funds and Asian banks may also delever.

Regardless of the initial magnitude, we emphasize that any deleveraging activity may be damaging for markets: as we saw in 2008, forced deleveraging begets further deleveraging, as declining prices force more and more investors to liquidate their positions.

The JP Morgan analysts summarize their overall conclusions:

Our main conclusions are as follows:

– A technical default raises the risk of a flight to liquidity out of government money funds, potentially triggering an increase in redemptions similar to that seen in 2008.

– Repo markets will be severely disrupted as haircuts are raised and could result in a significant deleveraging event.

– Even if the technical default is cured immediately, foreign demand for Treasuries could be permanently impaired. As a case in point, we note that even without any kind of default, Fannie Mae and Freddie Mac’s move into conservatorship has led to permanently lower foreign sponsorship of government-sponsored enterprise debt.

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Related RepoWatch stories:
– Fitch: Repo is potentially a ‘serious’ threat to money market funds if U.S. defaults, July 21, 2011
– U.S. debt default could freeze repo market, May 20, 2011