Stress Testing the United States

A curious thing happened on the way to August 2… Last week, professional money managers started asking us to perform Stress Tests on the US Government.  Gulp.

My company provides a variety of different risk management services for professional investors.  Among them is a ‘Stress Test’ for Money Market Mutual Funds in which we simulate a number of different simultaneous market downturns to show the fund’s managers what impact these hypothetical events would have on their ability to continue to provide liquidity at $1.00/share.  Typically, we simulate three simultaneously ‘bad’ things happening: interest rates rising (so bonds lose value), credit spreads widening (so bonds lose value) and fund investors increasingly redeeming shares (so the fund has to sell bonds – potentially at a loss – to have the cash to pay back investors, a vicious downward spiral).  For most of our clients, we perform these stresses monthly.

Last week, we got calls from several clients asking us to run these stresses in the middle of the month because they’re concerned with the US not raising the debt ceiling.  The fact that professional money managers are paying us to perform a stress test on the US Government should ring alarm bells. Let me describe what they’re worried about:

If we don’t raise the debt ceiling by August 2, the US Treasury will not have access to sufficient funds to pay all of its debts.  That doesn’t mean it automatically defaults – it means that the government then has to start deciding which bills to pay and which ones not to.  They could decide to not pay out Social Security.  Or to not pay government employees.  Only if the US decides to not pay back any debt (interest due on bonds, etc.) is it usually considered a default.  But heck, the credit agencies may decide that any missed bill payment constitutes a ‘technical default.’  Either way, if we don’t raise the debt ceiling, then that dollar bill in your pocket – which is backed by ‘the Full Faith and Credit of the US Government’ – just lost some of its credibility and buying power.  So that means interest rates will surely rise.  And credit rates will too.  That’s two of the three things that our Stress Tests monitor.  What else will very likely happen?  People, and institutions, will want access to their money.  Cash.  Fast.  That’s the third things we monitor – Money Market funds’ ability to provide investors with their money back.  Actually, these very Stress Tests are part of a new set of US government regulations stemming from the financial crisis of 2008.  How do you get more ironic than that?

It’s usually not so bad if a fund is hit by any one of the three shocks we monitor, so long as it’s one at a time.  Most, if not virtually all, Money Market Funds can withstand quite a bit of rising interest rates.  If interest rates go up by even a full 2% or 3% overnight they can usually weather that storm.  It’s also usually OK for them if credit spreads widen – again, most can withstand that shock too.  And fortunately for all of us most of them can withstand large redemptions.  Typically, as much as 50% of the investors (or more) can demand their money back and the fund is still OK.  But if all three of these hit simultaneously then most funds have little wiggle room.  In such a ‘perfect storm,’ where interest rates go up by say 1% and credit spreads are similarly up, many funds can’t withstand even a 20% redemption before they have to close their doors or look to (oops!) the Federal Government for aid.  If the thought of a few of these funds going under doesn’t bother you, let me remind you that it took just one such Money Market Fund going under at the beginning of the last (still ongoing?) crisis that triggered the $700B Federal Bail-Out.  These Money Market Funds are the backbone of the US money supply to investors, corporations and individuals like you and me.

In a previous post, I wrote that watching the price of gold would be a good way to monitor the probability of the US not raising the debt ceiling.  But after last week, I think I found a better measure: the number of professional funds that run simulations of just such an event.

Post Script.  (can you do a PS in a blog?) Most people say this situation is unprecedented.  But I’ve read a couple of articles recently claiming that “in fact, the US has been in this situation before – look at Shay’s Rebellion.”  Uh ya, that was in 1786.  If the implication is that it’s OK to go down this road because ‘these are charted waters’ let me point out that I would hope we’ve learned a thing or two since 1786 when, for example, life expectancy in the US was below 60 (according to Wolfram Alpha), we still leached people to ‘cure’ diseases and you could still smell the smoke from the Salem Witch Trials (well, not really, but you get my point).

2 Responses to Stress Testing the United States

  1. Alisher says:

    I wonder how many funds are running the simulations for US default…

    • Alisher – An actual US default would, I think, basically be modeled as “interest rates up” and “credit spreads up.” The Stress Tests we do simulate a number of different moves – interest rates up 50bps, up 100bps, 150, 200, etc. Similarly with credit spreads – up 50,100,150,… and we show the results in a grid so you can see what happens for any combination.

      How much will interest rates and credit spreads rise if the US actually defaults? That’s impossible to tell. So the best that can be done is figuring out what happens at different combinations of interest rate and credit spread and redemption amounts.

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