Stan Collendar on the debt limit

From Roll Call, reprinted on his blog.

The best indication of all that the market has already started reacting negatively is the current trading of credit default swaps on U.S. debt. As of late May, the number of CDS contracts — essentially insurance policies on the possibility of a default — had risen by 82 percent. Equally as important, the cost of a CDS — the best indication of how much riskier U.S. debt has become — rose by more than 35 percent from April to May. Last week I spoke to a number of people who calculate such things for a living, and they said this change means that the interest rate the U.S. government has to pay has already increased by as much as 40 basis points compared with what it otherwise would be. This means higher federal borrowing costs and deficits, and overall higher interest rates on everything from car loans to mortgages to credit cards.

What should S&P and Moody's do? Should they take seriously the possibility that the US will default? Everyone "knows" that this is all political gaming and it will never come to a real default. But then, that's always the case before something unexpected happens: no one believes it could possibly happen. If it does happen and S&P and Moody's hadn't taken the possibility seriously, they would be criticized for missing something that was obvious—in the same way they missed the mortgage meltdown. So they should take it serious—just as if it were happening in some other country that is immature enough that it may allow something like this to happen. And perhaps it will really happen.

Except when something unexpected occurs, the initial changes in market psychology and behavior start with just a few investors who act either because they are more or less risk averse, have better information, or are smarter. That means there are usually small signs of change before a market tsunami hits. In this case, there is now clear evidence that the uncertainty over the federal debt ceiling is already having the negative impact on financial markets that the Republican leadership has said will not occur. Just because it may not yet be obvious to everyone doesn’t mean it’s not happening.

Not only that, I'm sure I'm not the only person who has thought these thoughts. As the deadline approaches, more and more people are likely to become more and more uncomfortable and will look for a safe place to put their money. Where is that? I don't know. Not the usual place, U.S. Treasury notes. So where? Cash? That has to be stored somewhere. Money market funds won't do since they depend on Treasuries. Even bank deposits may seem unsafe since who knows what will happen to the banking system. Something solid like commodities or precious metals? Or perhaps companies that for one reason or another are likely to be needed after the crisis and are not likely to fall apart.

After all, the world will go on. We must all eat. It's not the case that everything will grind to a halt. And in the worst case, the Republicans will see how much damage they are doing and retreat—one hopes. But I'm sure quite a few people are right now attempting to imagine possible scenarios and looking for ways both to protect themselves and perhaps even to make money.