Default Risk: Wall Street’s Shocking Debt Denial

Zachary Karabell says our complacency will blindside us, just as it did when Lehman Brothers collapsed.


"The United States is not going to default on any obligation. We are not a credit risk, believe me." Calm words, coming from the financial sage of Omaha, Warren Buffett, and words meant to keep the markets calm in the face of mounting hysteria in Washington over the debt ceiling and potential default of the U.S. government. This perception—that Washington may go to the wire on Aug. 2 but that in the end, sanity will prevail—is widely shared on Wall Street and on bourses throughout the world. That is almost as disturbing as the debt mania, because if Buffett and the financial community are wrong, they are wholly unprepared for the consequences.

It’s not as if this is a sudden crisis. It has been percolating for months, at least since the tidal wave that swept freshmen Republicans and Tea Partiers into the House of Representatives in November of last year. Or if that was too amorphous, at least since early spring, when the likes of Eric Cantor and Paul Ryan began laying markers in the sand that they would countenance no new taxes, would demand drastic spending cuts, and would use the debt ceiling as leverage.

The closest parallel may be the collapse of Lehman Brothers in September 2008, which as we know all too well set off a chain of reactions that brought the global financial system to the brink of an abyss. That too was well telegraphed throughout the summer of 2008, yet market makers remained convinced that in the end, the worst that would happen would be the absorption of Lehman into a larger firm, just as happened with Bear Stearns earlier that year. Having underestimated the risks of Lehman, you would think that no one would now underestimate the risk or probability of a U.S. default

But even that parallel falls short, in that credit markets—which are the lifeblood of daily global commerce—were signaling high levels of anxiety and concern about the possible effects of a Lehman collapse well before Sept. 15. Even then, no one was prepared for that outcome, and every major financial institution in the world stared at the possibility of insolvency.

Today, global markets are discounting the risk that Washington politicos might just call everyone’s bluff and fail to reach a resolution before early August. Intrade, the online market where one can bet on events, does have a resolution before July 31 at just less than a 50 percent probability, but even that means that there is no “wisdom of crowds” dictating a high risk of U.S. sovereign default. And as for the pricing of assets globally, there is absolute complacency.

The signs of complacency are everywhere. U.S. bond yields are not rising sharply on concerns of default (they have in fact been going down this month), and spreads between short- and long-term bonds aren’t widening. Equity markets aren’t selling off as investors seek to raise cash and keep themselves inoculated. Investors aren’t dumping dollar-denominated assets; gold isn’t soaring; banks are not scurrying to raise capital or reserves to protect themselves against a possible global tidal wave of panic. European banks are raising capital because of concerns about Greek debt, Italian debt, Portuguese debt, but not as a precaution against U.S. default.

It is hard to fully account for this complacency. It may be that for Wall Street and the financial community, the perils of default are so evident and unarguable that the idea that politicians might commit ritual group suicide is unthinkable. They must come to their senses in the end, right? To do otherwise would be madness, and while Washington is often touched, in the end the political class can be counted on to do just enough to avert disaster.

That is not a safe or prudent assumption. Yes, President Obama articulated once again in his Friday press conference the need to resolve this issue, and even some senior Republicans have genuflected toward that need. But from time to time, politicians and governments make the worst possible decisions. Remember that the Smoot-Hawley Tariff passed by large majorities in 1930 and was endorsed by President Hoover, raising trade tariffs at exactly the moment that the system needed them lowered. That alone should alert us to the fact that while governments usually muddle through and avoid the worst possible outcomes, we should not blithely assume that, this time, the U.S. government will do what is necessary just because we know how dire the consequences will be if it doesn’t.

The other dynamic is that for all the ills of the United States both economically and culturally, the U.S. economy remains an anchor of the global system. China is emerging as another pillar, but for now it is still tethered to the U.S. dollar and depends on the full faith and credit of the United States as intimately as anyone does in Iowa. If the United States really jumps the fence on this one, the world will be left in a precarious position with no Plan B. So everyone waits and hopes and pretends that the risk is minimal.

The result is that the financial world, from investors to institutions to finance ministries, is in denial about the risk that the U.S. might just default. No one is prepared, and no is preparing. Most alarming is that we seem not to have learned from the financial crisis about the perils of complacency. And so we had better hope that for now, this complacency is justified, that cooler heads do prevail, and that an agreement is reached. Because if not, we are in for a truly unpleasant ride.