Countdown to D-Day

The United States government is now just eight days from D-Day — the day of debt default.

If it actually happens, the ensuing chaos could bring the end of the United States as we know it today.

And if it’s averted, any substantive agreement by our leaders in Washington is bound to cause an historic sea change in America’s economy, politics, and society.

Irreparable Damage

Already, regardless of what our leaders may do in the next eight days, their inability to come to an agreement this close to D-Day has damaged both the credit and credibility of the United States government.

S&P and Moody’s — historically biased strongly in favor of the U.S. — have put the government’s debt on credit watch for the first time in history.

Our own rating agency, Weiss Ratings, acting sooner than all of the above, recently downgraded U.S. government debt to a C- (approximately equivalent to a BBB- at S&P).

And global investors, remarkably complacent until this past Friday, are now scrambling to prepare for the possibility of default.

These actions are historical fact — a signal that damage has already been done and could be permanent.

What Would Happen If Washington Defaulted?

The precise outcome is inherently unpredictable.

In the inevitable market panic that would ensue, no one can anticipate exactly what investors might do.

In a moment of madness at the Fed, no one can know ahead of time how Chairman Bernanke would respond.

And in their rush for self-defense, certainly no one can say how China, loaded with U.S. Treasuries, or Europe, reeling from its own debt crisis, would react.

But we do have one recent precedent that can provide some insight: Just three years ago, global financial markets came dangerously close to a fatal meltdown even in the absence of sovereign debt defaults.

Hundreds of billions in mortgages went bad.

Bear Stearns, Lehman Brothers, Washington Mutual, Wachovia, Merrill Lynch, Citibank, and Bank of America filed for Chapter 11, and were bought or bailed out.

The all-important short-term credit markets, where thousands of corporations go to raise quick cash, froze up.

Money was unavailable at virtually any price, threatening a cash squeeze that would drive thousands of large companies into Chapter 11.

Derivatives — high-risk bets on all kinds of markets or events — blew up.

U.S. financial markets were on the brink of Armageddon.

Therefore, almost by definition, the consequences of a default by the United States government itself would be more severe than anything witnessed during the great debt crisis of 2008.

Here’s why:

* Then, the catalyst of the crisis was a small niche sector of one type of debt — subprime mortgages

This time, the catalyst would be the federal debt of the largest economy in the world — the issuer of the world’s dominant reserve currency … the world’s sole military superpower … the center of global financial markets … and ironically, the country with the single largest pile-up of debts in history.

* Then, the epicenter of the crisis was a small niche in the derivatives market called credit default swaps — a type of insurance against the failure of major borrowers. And according to the third quarter 2008 report by the Comptroller of the Currency (OCC), at around the time of the Lehman Brothers failure, U.S. banks held $16.1 trillion in these credit default swaps.

This time, the epicenter of the crisis would be the sector most directly impacted by a Treasury default — interest-rate derivatives. And this time, the amounts involved would be far larger: According to the OCC’s first quarter 2011 report, U.S. banks now hold $199.5 trillion in interest-rate derivatives, making this sector 12.3 times larger than the one most directly impacted by the last debt crisis.

* Most important, in the 2008 debt crisis, a total collapse was averted thanks only to the direct and massive intervention by the U.S. government — $700 billion in rescue capital from the U.S. Treasury plus an estimated $14 trillion in government guarantees for virtually every kind of credit imaginable.

This time, it is the U.S. government itself that’s facing its own Day of Reckoning— and there is no power on earth rich enough to bail it out.

How Bad Could It Get?

The Secretary of the Treasury and the Federal Reserve Chairman warn of Medicare and Social Security checks canceled … salaries to soldiers unpaid … critical government functions shut down.

That’s true. But it’s not the entire truth.

The pundits say that a consequence of a U.S. government default would be sharply higher interest rates.

That’s also true, but also not the whole truth.

In reality, it would be a lot worse than that: If the United States truly fails to make payments on the interest and principal of U.S. government securities, here’s a likely scenario that would ensue …

The largest and most important kind of market in the world — the market for all forms of credit — promptly shuts down. Virtually all buyers recoil in horror. Any vestige of liquidity disappears.

Forget about interest rates! Money is virtually unavailable at any cost. For overnight money, desperate borrowers in the U.S., like their counterparts in European crises of recent years, offer annual rates of 20%, 30%, even 100%, but most still can’t find willing lenders.

Government officials scramble to minimize the danger. But no matter what they say or do, there is no answer to this fundamental question:

If U.S. Treasury securities — THE benchmark of quality and liquidity for all other debts everywhere — are themselves in default, how can any other debt or loan be safe? How can we trust any bond of any corporation, local government, state government, or foreign government? How can we trust commercial paper (short-term corporate IOUs), bank CDs, insurance policies, or any other contractual obligation?

With this collapse in confidence and with money so scarce, anyone with debts coming due — which is almost every borrower in America — risks a cash squeeze and default. Only companies that are rich in cash and virtually debt free survive.

Financial markets cease to function normally. Banks close nationally. Business transactions of all kind become extremely difficult, if not impossible. The entire economy sinks into paralysis.

The individual consumer is blown away by the fallout — no cash flow for employers, no paychecks for employees.

The U.S. stock market, the U.S. dollar, and virtually every U.S. asset collapse in value, with many markets shutting down entirely. The price of gold skyrockets.

Is This Really Possible?

If Congress and the White House fail to raise the debt ceiling and allow a permanent, outright default by the U.S. government to occur, yes.

What’s more likely, however, is this scenario:

In the days ahead, global financial markets give Washington a sneak preview of the scenario I’ve just described. And then, finally, our leaders are so spooked by what they see, they rush to make a final deal in the 11th hour.

But remember: A deal to make big cuts in U.S. government spending — on top of an already sinking economy — will NOT end this crisis.

It may trigger some temporary relief buying on Wall Street. But it will also drive the U.S. economy into the same four-step vicious cycle we now see in Greece and other European countries:

1. A shrinking economy and sinking government revenues, which cause …

2. Out-of-control budget deficits, which require …

3. Big cuts in government spending, triggering …

4. More declines in the economy and further shrinkage in government revenues.

In Any Scenario, Your Course
Of Action Should Be the Same …

First, unload and avoid all medium- or long-term government securities — including those issued by the U.S. Treasury, Ginnie Mae, Fannie Mae, Freddie Mac, or any government agency.

Right now, their notes and bonds are still fetching premium prices in liquid markets. But that could change very quickly. So don’t wait. Sell at the market.

Second, if you haven’t done so already based on our guidance in Safe Money Report and other publications, increase your allocation to gold bullion or equivalent.

The world’s largest gold bullion ETF — GLD — is still viable. Plus, you can purchase gold bullion coins from American Century, Dillon Gage, FideliTrade, Manfra, Tordella & Brookes, Rare Coins of New Hampshire, or another reputable dealer.

Third, substantially reduce your exposure to U.S. stocks, starting with the most vulnerable. For a reliable opinion on which those are,

• Sign up or sign in at www.weisswatchdog.com,

• Search for your stocks (using the first word of the name only),

• Add them to your Watchlist, and then

• Check your Watchlist to see the latest rating.

Fourth, for vulnerable investments you do continue to hold, be sure to hedge. A handy vehicle: Inverse ETFs that are designed to rise in value when your investments fall. Specifically,

• To hedge against a decline in U.S. Treasuries, you can use the ProShares UltraShort Lehman 20+ Year Treasury ETF (symbol TBT), and …

• To hedge against a decline in U.S. stocks, consider the ProShares Short S&P 500 ETF (SH).

Above all, stay safe!

Good luck and God bless!

Martin