What to expect when you’re expecting a default

An economist suggests companies model four possible scenarios.
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· 3 min read

With Janet Yellen warning that the US could default on its debts as early as June 1, the pressure is on for lawmakers to strike a deal. The consequences of a default could be “catastrophic,” RSM economist Tuan Nguyen cautioned. Though he believes a default is unlikely, he encouraged businesses to prepare for one just in case.

If Washington doesn’t manage to raise the debt ceiling, the US could enter either a technical or full default, Nguyen, who holds a PhD in econometrics and quantitative economics, told CFO Brew. A technical default would occur if the US failed to pay some or all of its debts for an extended period of time, while a full default would occur if the country stopped paying its debts altogether. Either scenario would have devastating effects on the economy.

A full-scale default, he said, “would be worse than the 2008 financial crisis, because it would be something that we have not seen before,” and therefore hard to predict.

In fact, the current uncertainty over whether the US will be able to pay its debts is already having ripple effects upon the economy, Nguyen said, pointing to the credit-default swap market as an indicator. In late April, Reuters reported that spreads on five-year credit-default swaps were at their highest level since the 2011 debt crisis, and more than double what they were in January.

Plan ahead for a few possible scenarios. Companies should have a plan in place to respond to a government default, if it happens, even though the probability of it is low, Nguyen said. “You don’t want to be caught in a crisis without any tool that you can use to react to the crisis,” he observed.

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Nguyen said we are looking at three to four “distinct scenarios”: no default, a technical default, a full default, and, though unlikely, a scenario where “the government comes out with a new policy that addresses the debt ceiling.” It is important to account for how prices, demand, and investments might be affected by each of the scenarios, Nguyen said.

In any default scenario, companies would face higher borrowing costs, lowered demand, and lower spending. Employment would also be affected. A default would “accelerate layoffs and hiring freezes in the next one to two years,” Nguyen predicted.

Financial portfolios would be affected “immediately” as the interest rate would increase on Treasury bonds, which would drive the interest rate on loans up as well.

There would be lower demand in the manufacturing and consumer sectors, Nguyen said, and companies in those industries might look to “have to have a plan of cutting down activities, cutting down production, while keeping everything efficient,” which would likely lead to job cuts, he said.

A scenario in which the government figured out a way to eliminate the debt ceiling is harder to model because it would be “new territory,” Nguyen said.

However, “the cost of a default would be too significant for the US to go through,” Nguyen said. “So in any scenario, we’ll want the government to settle the debate and avoid a default.”

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The latest news and insights corporate finance professionals need to know to keep up with their constantly evolving industry.