Federal Reserve Actively Preparing for the Possibility of US Default

The Federal Reserve is actively preparing for the possibility that the United States could default as a deadline for raising the government’s $14.3 trillion borrowing limit looms.

Lawmakers in Washington are racing to reach a deal to save the country from defaulting on its debt, but on Wall Street, financial players are devising doomsday plans in case the clock runs out. Photo: Breaking Media/Flickr

Financial players on Wall Street are devising doomsday plans in case the clock runs out. These companies are taking steps to reduce the risk of holding Treasury Bonds or angling for ways to make profits from any possible upheaval.

And even if a deal is reached in Washington, some in the industry fear that the dickering has already harmed the country’s market credibility.

Treasuries on Wall Street function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets.

Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value.

In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee.

The rating agencies, which control the fateful decision of whether the nation deserves to have its credit standing downgraded, are surveying other entities that would be affected by a United States default — like insurance companies and states — and issuing warnings that a United States downgrade could result in several other ratings cuts.

States that might be downgraded, in turn, are trying to reassure the market that they could still pay their bills on time.

Charles Plosser, Philadelphia Federal Reserve Bank President,  stated that the Fed has for the past few months been working closely with Treasury, ironing out what to do if the world’s biggest economy runs out of cash on August 2.

In the interview Charles Plosser asserted: “We are in contingency planning mode. We are all engaged … It’s a very active process.”

Plosser also said he had a feeling that President Obama and Congress will come to an agreement to increase the Treasury’s borrowing authority in time to avert a default on government obligations.

Obama had to meet with top Republicans in Congress Wednesday so as to discuss the latest attempts to end the dispute over raising the country’s debt ceiling, a row which has raised the prospect of the Treasury Department running out of money to pay its bills next month.

The Treasury repeated that default was improbable and that there was no alternative to raising the debt ceiling, and Plosser’s remarks marked the most extensive public comments on the matter from a U.S. official.

Plosser also said that the Fed is developing procedures about how the Treasury will let it know which checks will get cleared and which won’t.

The Fed acts as the Treasury’s bank – it clears the government’s checks to everyone from social security recipients to government workers.

Plosser asserted: “We are developing processes and procedures by which the Treasury communicates to us what we are going to do. How the Fed is going to go about clearing government checks. Which ones are going to be good? Which ones are not going to be good?”

He also added: “There are a lot of people working on what we would do and how we would do it.” Plosser said that there are a few difficult issues that the Fed itself had to grapple with.

The Fed lends to banks at the discount window against good collateral.  Plosser stated: “Do we treat them as if they didn’t default, in which case we would be saying we are pretending it never happened? Or do we treat them as if they defaulted and don’t lend against them? Those are more policy questions.”

Plosser, who was a vocal critic of some of the Fed’s extraordinary lending during the financial crisis, warned it would be crucial for the Fed not to do the Treasury’s work for it.

He said: “We have to be very careful that we don’t become, that we don’t conduct fiscal policy in this context. That we don’t substitute for the inability of the Treasury to borrow in some circumstances.”

Plosser is a voting member of the Fed’s monetary policy-setting committee this year. [Photo via Breaking Media/Flickr; via Huffington Post, The New York Times and CNN]

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