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The U.S. Default Challenge


No one wants the kind of panic that nearly ensued when the Reserve Primary Fund broke the buck on Sept. 15, 2008. In the three days following, there was a near-run on money market funds, with $169 billion in redemptions.

That run could have continued had not the Treasury quickly stepped in and ended the outflows with an insurance program to guarantee a $1 net asset value for all money funds.

Level heads, including those at the Investment Company Institute, are telling investors that should the U.S. government fail to raise the $14.29 trillion federal debt ceiling, the impact on money market funds would be minimal. Others maintain that the likelihood of the government failing to raise the debt in the first place is practically nil.

But should the U.S. default and the market enter a crisis of confidence in the stability of the debt market or if ratings agencies downgrade the U.S.'s triple-A credit rating after a century at that pristine perch, money market fund investors could certainly rush to the exits, in droves. That could lead to a fire sale of fixed-income securities that would have grave implications for markets and economies around the world.

Why? Because the $2.67 trillion money fund industry invests heavily in U.S. government bonds, just like the Reserve Primary Fund was heavily into Lehman Brothers assets.

Money market funds own a total of $1.175 trillion in government debt, $684 billion in securities issued by the Treasury and government agencies, and $491 billion in repurchase agreements.

Nonetheless, the ICI says, the issue of the debt ceiling and ratings downgrade is centered on U.S. long-term debt, not the high-quality, short-term paper that money funds hold.

Nevertheless, there is the possibility that if the U.S. long-term debt market goes into diarray, the short-term market could be disrupted, as well.

The ICI addresses this scenario, saying that should the ratings agencies cut their ratings on short-term U.S. government securities, they would have to bring them down the equivalent of eight notches along the 22-step long-term scales of Moody's and S&P. That would mean a downgrade from Prime to Non-Investment Grade. But none of the agencies are discussing taking a step of "such severity," the ICI says.

Further, the ICI continues, should a U.S. debt default roil the markets, money fund boards can determine that disposal of their holdings would not be in the best interest of the funds or their shareholders.

The ICI line of reasoning ends there.

What the ICI does not add is that if money funds were forced to hold onto their securities in a disorderly market, the funds could appeal to the Securities and Exchange Commission to halt redemptions. Which of course would lead to more panic.

S&P attests that this scenario would create a "precipitous drop" in money market fund NAVs.

We have already witnessed the near-disastrous ripple effects of $785 million in exposure to Lehman debt at the $65 billion Reserve Primary Fund.

The chain of events that would ensue in the event of a U.S. default on even a similar amount, $172.7 billion, of the $14.3 trillion in debt it owes its creditors is unfathomable.

If Congress doesn't raise the debt ceiling, the government could be forced to raise funds anyway-to backstop money funds and a host of other investments.