'Financially Challenged Legislators' Have No Clue What Default Would Mean: Bove

NEW YORK (TheStreet) -- President Obama seemed a bit annoyed that the stock market hadn't seen a major decline during the first two days of the government shutdown, when he said Wednesday afternoon that investors "should be concerned."

The broad market rose on Tuesday, the first day of the government shutdown, resulting from a budget impasse between the Republican-led House of Representatives and the Democrat-led Senate. The last shutdown occurred in 1996. The current shutdown has 800,000 federal workers on furlough, and Credit Suisse economist Andrew Garthwaite in a client note on Wednesday estimated that "even a 22 day shutdown (as under Clinton) would take only around 0.2% off GDP." The timing of the shutdown at the beginning of the fourth quarter could also work out well, assuming Congress comes to an agreement fairly quickly, since there's still plenty of time for federal agencies to make up for delayed spending before the end of the year, which would limit the effect of the shutdown on economic growth.

The president may have taken some grim satisfaction that the market began to decline on Wednesday and declined further Thursday morning, following his failed meeting late Wednesday with congressional leaders.

The potential for a default on interest payments by the U.S. Treasury is of far greater concern to investors.

Last Wednesday, as lawmakers were trying to strike a deal to keep the entire federal government operating, Treasury Secretary Jack Lew in a letter to Speaker of the House John Boehner (R., Ohio) said the "extraordinary measures" the Treasury was taking to maintain its borrowing power would "be exhausted no later than Oct. 17," unless the $16.7 trillion federal debt limit is raised.

Over the past few years, the recurring "debt ceiling" debate has revolved around the major ideological differences between the major parties, and within the Republican Party, as some legislators refuse to budge from their desire to defund the Affordable Care Act, and their desire to tie each increase of the federal debt limit to specific cuts in spending.

Each period of recent debt-limit brinksmanship has ended with a compromise before any threat of government default, which has muted the market's reaction. With the current debate also involving a government shutdown, things may be different this time.

"A shockingly high number of Americans -- 50% among some groups -- think that it would be good" for the U.S. government to default on its debt payments, according to Rafferty Capital Markets analyst Richard Bove, who has been an outspoken critic of the "extortion" of JPMorgan Chase (JPM) by the Department of Justice and regulators.

In a note to clients Thursday, Bove broke down the estimated $16.7 trillion owed by the U.S. government, showing that $4.8 trillion in Treasury bonds and notes are held by the Social Security fund and other government agencies, with the Federal Reserve holding $1.9 trillion.

A default by the Treasury would therefore hurt key agencies, including those relied on by retirees. The default would cause the value of the securities backing more than half of the Federal Reserve's balance sheet "to plunge," according to Bove, who wrote that "This would raise the question of what is behind the value of the dollar. Depending on the size of the decline it could wipe out the equity at the Fed."

Bove estimated that money market mutual funds hold $449 billion in Treasury paper, and that a government default would make it "virtually impossible" for fund managers to maintain the stable one-dollar share prices of the money funds, and that "millions of Americans would lose billions of dollars."

Going further, the Federal Reserve said that U.S. banks and thrifts -- that is the insured depository institutions themselves, and not the bank holding companies -- held $194 billion in Treasury bonds and notes at the end of June. A disruption of interest and principal payments on these securities would certainly cause tremendous pain for the banks, their holding companies and for investors.

The banks also hold $1.73 billion in debt securities guaranteed by agencies, including Fannie Mae (FNMA) and Freddie Mac (FMCC), according to the Federal Reserve.

Bove underlined the threat to the banks: "A reasonable estimate would be that the U.S. banking industry owns $1.85 trillion in government backed securities. It has $1.63 trillion in equity. If the Treasury and related securities were in default, one does not know what they would be worth."

All the above fails to consider the powerful effect a default would have on the standing of the United States in world credit markets. According to Bove's estimates, governments and investors outside the U.S. hold $5.6 trillion in U.S. government obligations.

Bove's conclusion doesn't make for pleasant reading, but maybe the Washington gang will realize before it's too late that differences in ideology and their personal agendas, including reelection fund-raising, pale in comparison to the damage a federal government default would bring:

"It is actually shocking that I would write a comment of this nature," Bove wrote. "The devastation to the United States would be so severe that it would take decades to recover from the Depression caused by a default and the attendant dumping of trillions of dollars of U.S. Treasury securities on the global financial markets."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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