n-Financial Science Fiction: Pre- to Post-Credit Default

Some quick notes drawn from an alien planet spying on Earth's financial economic activities:

1.  If the US government, and specifically, the US Department of the Treasury cannot pay on its obligations when due then it is technically, insolvent, and it is declared in default as per the conditions set by bilateral legal agreements called financial contracts including straight bonds, futures, options, CDS and thousands of different kinds of interest-related over-the-counter derivatives. As of this moment in time, Thursday, July 28, 2011, neither the President of the United States nor congressmen or senators of the US have come up with a plan that meets even a modicum of credibility to the financial markets. As of July 27, major funds are positioning their books to take on the inconceivable--a default of US government obligations. On August 7th, 2007, we had a seizure of the very short-term money markets, in effect, the liquidity of the Western world, shrank from $600 billion per day in trading volume to notjhing, nada, zilch! The former Goldman Sach's CEO, and chief discretionary trader of the US at that time, Hank Paulson, one year later diverted $750 billion to save four big entities on Wall Street, which entities would continue to receive life support subsidises in the form QE1 and QE2, and by the grace of the Fed window, be able to trade "dead mice" (RMBS) for an astounding $14+ trillion in combined subsidies over 3 years. This profligacy of overt moral hazard can be compared to Nero playing the fiddle while Rome burned. Gold has zoomed above $1630 per ounce whence it was $500 per ounce 5 years ago. The charade of "panem et circenses" has come to a dreaded faltering halt by the US Fed as of May 6th when it announced no more QEn. That announcement has been completely discounted and manipulated by the ALGO traders on stock markets at low volumes at the close of trading (the so-called "compression trade"). The compression trade disappeared last Monday, July 25th. And yesterday, someone swallowed a very bitter pill and sold 65,000 futures contracts on US T-Bills! If this sort of trade occurs pre-default, only a sic fi writer of first rank can imagine what will happen as August 2nd comes and goes.

2. The markets are factoring between a 35 and 85 basis point hit in the US treasuries. The knock on tsunamic effect will be difficult to contain. Here are some headline inevitabilities:

(1) All sovereigns will be rated downwards except for the oil producers. The cost of capital will be driven prohibitively high for non-oil producing states. This means most of Europe except Gernany which enjoys a trade surplus will temporarily destroyed with extraordinary risk premia.

(2) Pension Funds and Insurers will be forced to move to safer bonds whatever that means in a sea of utter volatility. These moves are mandated by US Federal laws requiring that such funds hold AAA securities. So the law will have the unintended consequence market euthanasia.

(3) For similar reasons, the shadow banking sector, i.e., Money Market Funds (MMFs), will lead the pack, by complying with Rule 2(a)7 and immediately withdraw support for non-AAA bonds. This can cause genuine global illiqudity since without the MMFs 3 to 4 trillion dollars of very short term money suddenly goes into deposit and no bank, no corporate, no government can move any money since collateral lines will be totally frozen.

(4) Municipal bonds are downrated in relation to the US downgrade. This will make completely naked the 38 states in the US that are trading insolvent.

(5) if (3) or (4) occur then expect the US Fed and Treasury to pump another trillion dollars to prop up the failing Wall Street banks--obviously, Bank of America is getting near the threshold of the dead zone abyss and Citi will not be a beneficiary of any short-term chaos. Good luck if you want to play the river for a pair of aces.

We can list at least a hundred different effects a US default will cause, but all of these can be understood under a theory of Default Invariance. See my previous blogs. By the way, one the beneficiaries of the coming US de facto default is textbook publishing because ALL TEXTBOOKS ON FINANCE will need to scuppered and re-written. The ENTIRETY OF FINANCIAL DOGMA since the 1950s has proved itself to be less worthy than astrology.