Sunday, July 17, 2011

How could a government default affect your personal finances? Some answers.

Congress must raise the debt ceiling by two weeks from Wednesday or the federal government will no longer be able to pay all of its bills and may end up defaulting on its obligations including its obligations to pay interest on its debt.  How might a default affect your personal finances?  Here are two predictions concerning what to expect.  The first is from Greg McBride at  The second is from Alan Binder, former Vice Chairman of the Fed.

Greg McBride

Greg McBride at described what would likely happen if the debt ceiling in a recent post.  It is not a pretty picture, affects everyone in the country and would result in a public and private financial disaster from which no one could escapte.  Don’t read what follows if you want to sleep tonight.  Greg’s predictions are truly THAT scary.

First, you'd have a rapid re-pricing -- in a downward direction -- of all financial assets, not just Treasury debt. Why? Government debt is considered risk-free and America's "risk-free rate" is fundamental to the pricing of all financial assets, like stocks. Recall the mayhem of 2008 when asset prices plunged as panic spread.

But this time, there would be no place to hide. In 2008, nervous investors fled to the safety of U.S. Treasury securities. As an asset class, they performed well as a result. But in the event of default, this safe haven would no longer be a safe haven. The unthinkable would likely soon happen: America would see its enviably unblemished credit rating cut.

Any cut in the U.S. credit rating would cause a stampede out of Treasuries. That would produce a domino effect, with 401(k)s, IRAs and college savings accounts plunging in value as the holdings they're invested in melted down. Faced with a sell-at-any-price panic mode, even some pensions could have trouble meeting their obligations due to rapidly falling asset prices.

Next, we'd quickly have a renewed credit crunch on our hands. The new market mantra would be, "If the U.S. can default, anybody can." No one would want to lend to anyone. The flow of credit would come to a screeching halt. A run on money market funds could begin. Only this time there wouldn't be a government backstop, like the one erected in 2008 to calm fearful markets.

As investors abandoned Treasuries, the prices would plunge. So yields -- which move inversely to price -- would bolt upward. And that is where consumers of every stripe would take a hit. They would see higher rates for mortgages and consumer loans. Furthermore, credit lines would be frozen or cut for businesses and consumers. Companies would shed workers in a bid to conserve cash, producing a rapid economic deceleration much like the fall of 2008.

Alan Binder:

Here is the prediction of  Alan Binder, former Vice Chairman of the Fed

"By dint of what comes in on a day-to-day basis, the government can keep paying about 60 percent of its bills, and will fail to pay the other 40 percent."

If you are due to receive a paycheck, benefit check, Social Security, unemployment benefits or any other payment from the Federal government, you may not receive it after August 2nd.  While you may be paid eventually, the delay could last from days to months to years.

If you try to borrow money after August 2nd, you will probably have to pay a higher interest rate.  Rates would likely go up for credit cards, home mortgages, auto loans, student loans, just about all loans.  Worse, you might not be able to get a loan at all.   Binder says, "If the markets really go into a tizzy, we may get to a situation in some markets where the rates hardly matter at all because you just can't get credit."

Binder predicts that the country will “almost certainly” be pushed back into another recession even if the Treasury finds a way to pay interest on its debt with the revenue coming in since, he says, a sudden 40 percent drop in government spending would be disastrous for the economy.

Finally, says Binder, the stock market will take a huge hit as investors around the world lose confidence in the U.S. 

"You will get the investing community, not just of the United States but of the entire world, thinking that we've lost our marbles over here…And we will have — because [failing to raise the debt ceiling] is a completely crazy thing to do."

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