- Best Case, Worst Case, Likely Case

Since my buddy from the NYSE just called me and we were talking about it, I figured I’d give you guys a window into what I think are the worst case, the best case and the most likely case for the various option surrounding the debt ceiling debate. First lets start with the bad news:

The Worst Case:

The worst case assumes that there is no deal made, and the Treasury runs up against the wall. They’ve been leaking documents that indicate that they will not fail to pay interest and principal on US debt, whatever the circumstance. That’s good news and averts the worst of the worst possible cases. It means that whatever else may happen an actual ‘Default” of US debt is unlikely to occur. The NY Fed has also called in the Primary Dealers for a ‘chat’ this morning, and I suspect they’re talking about some extraordinary measure like I have discussed as an option in the past.

Failing that though, there isn’t enough money to go around, so someone somewhere isn’t going to get paid. In the worst case scenario, that event would be treated as a ’defacto’ default by the markets, and there will be a run on US issued paper. There will be a downgrade of US credit along with this, but the markets would be in such turmoil that no one will notice. The fed will not be able to leave this situation un-addressed so they will probably intervene in the markets, greatly expanding their balance sheet. Before it’s over, the dollar could lose up to 30% of its value against other currencies and gold.

The downstream consequences for the financial markets and for the broader economy will be catastrophic. Economic activity will halt, along with the normal functioning of most capital and money markets. Extreme measures like those which were implemented by Argentina during its default crisis would be put in place. Confiscation of retirement savings, mandatory investment in Treasuries would both be seriously considered and possibly implemented. As civil strife increased in reaction to those changes, martial law would not be out of the question.

This is an extremely unlikely scenario, but it’s not completely impossible. I personally would estimate the probability of an outcome like this at less than 2%.

The Best Case:

The best case is that a deal is made where President Obama and the Senate Democrats are politically compelled to accept a bill which includes major real cuts in spending, without adding an additional tax burden to the economy. This could avert the potential of a credit downgrade (something my friends and peers view as a 100% certainty in the present state of the discussion) and encourage increased economic growth.

This is an unlikely but still potentially possible outcome. I’d put it’s odds at somewhere between 5% and 10%.

The Likely Case:

A cross pollinated bill which combines some of the Reid plan, and some of the Boehner plan is passed by both houses on August 4th or 5th. The Treasury cobbles together some extraordinary measures to prevent a government shutdown, and the president signs the bill over the objections of his base, before the end of next week. The bill will be weak kneed jumble of lies and distortions which GREATLY overestimate the actual spending cuts, but at least does not include any new taxes.

This will not be enough to avert a credit downgrade, and both S&P and Moody’s downgrade US debt before Thanksgiving. This will cause an immediate 50 basis point rise in interest rates, and another 300 basis points over the longer term. It will also cause the downgrades to cascade to other states and cities with ‘at risk credit’, causing eventual insolvency in California, Illinois and a host of cities in deep blue states.

The Fed will react to higher rates by implementing a plan for expansion of it’s balance sheet in an attempt to avoid any negative economic impact or higher unemployment. Their plan will not be called QE3, but will involve the intervention in the Treasury markets, and the lowering of the value of the dollar. Under this scenario, I would expect gold to be above $2,000 per oz by the end of 2012 and $2,500 per oz by the end of 2013.

I think this is the most likely scenario, but there are an awful lot of ‘ifs’ embedded in there. I would still put it’s odds of being less than 50%, with the remainder of the outcomes involving only small changes to this version, and will produce outcomes equally similar to this scenario. It may take more or less time for a downgrade. They may trim more or less spending. The Fed may act sooner or later, by a lesser amount or more. But to the degree that Obama and Reid lose, America wins.



%%%%%%UPDATE%%%%%%

One thing I didn't really think about was the fact that the ratings agency's will be pressured by the Executive branch not to lower the rating.

The ratings agencies are a monopoly, and like all monopolies, they can only be enforced by government. So the ratings agencies have a long history of doing what government tells them to do. If you need evidence of their collusion with government toward achieving political goals, I refer you to the 2008 credit crisis, where every POS Mortgage bond Fannie and Freddie had any part of was rated AAA because the government wanted them to be.

However, while political pressure can make you swear that your feet are dry, they can't actually keep the tide from rising. And eventually reality will be so obvious to everyone that it won't matter what the credit agencies say. If they veer too far from what the markets consider 'reasonable' then for the sake of preserving their already threadbare credibility, they will have no choice but to lower the rating even though they were told not to.

They can put off a downgrade, but not indefinitely. I believe we'll be downgraded in time for the election, no matter what threats are levied against Moody's and S&P.