For those new to this dramaturgy, Congress has been setting a limit on the amount of federal debt outstanding since 1917, which invites perennial squawking by don’t-tax-don’t-spend fiscal hawks. Since 1960, the debt limit has been raised 78 times, 49 of them under Republican presidents and 29 times when Democrats occupied the White House. What’s different this time, at least so far, is that a voting bloc in the House has elevated the issue to a stagy level that magnifies the risks to capital markets that could develop if the hawks are able to hold control of that chamber over the debt issue.
So far, it looks like the anti-spenders are trying to craft a proposal that would keep certain checks flowing for Social Security retirees, law enforcement, defense and other off-limits spending channels, while freezing or trimming everything else. How that would impact federal payments to the states — which account for a third of their total revenues — is beyond the scope of this column. Instead, let’s focus on the implications for state and local cash and payroll managers of a debt ceiling crisis in capital markets if the U.S. Treasury debt market and operations of the Federal Reserve system are held hostage in the political fray.
The lurking issue for those cash managers is the operations of the U.S. Treasury Department if a debt ceiling hardens to the point that it exhausts the arsenal of delay tactics it has used before and can no longer pay off maturing T-bonds and T-bills when they come due because it lacks authority to issue enough new debt to refund those normal rollovers and pay interest when due.
This scenario could impact state and local cash management portfolios immediately, as the commercial money market would seize up. That’s true even for treasurers whose jurisdictions own no U.S. paper directly; many of them still hold short-term investments collateralized by federal obligations, as well as money market mutual funds, state investment pools and local government pools that own such securities. Prices of bonds held by the public and financial institutions could take a hit in market trading as liquidity risk becomes tangible, and it doesn’t take much imagination to see how markets worldwide could be spooked.
The Treasury secretary and responsible politicians will do everything possible to avert this doomsday scenario, and one would hope that centrists in the House majority caucus will come to their senses and join with members of both parties to pass a workable bill to sustain functional Treasury debt operations. But given the nature of how Congress operates, it’s likely that the edge of this abyss must be in front of their toes before somebody steps back. And before then, it’s almost inevitable that governing bodies responsible for oversight of state and local treasury operations will be quizzing their management teams about their liquidity plans. That’s what overseers are expected to do.
Contingency Plan Tactics
The most obvious starting point for contingency planning is to establish a true cash buffer to cover payroll and accounts payable. This may imply foregoing interest on a few short-term deposits, but there may come a time when that becomes cheap insurance against the nightmare of payless paydays.
To keep earning interest before their e-checks get cashed, smaller municipalities and qualifying pension funds should be able to construct portfolios of laddered bank CDs with FDIC insurance and short maturities. But that strategy won’t work for most states or for larger city and county portfolios with payrolls and disbursements that regularly exceed the FDIC limits. One workaround might be bank-issued repos or CDs overcollateralized with longer-dated government bonds, where state laws allow that strategy.
We’re still a few months away from having to put such tactics into action, but they should be part of most public cash managers’ contingency plans, along with a consensus as to when and how the staff would invoke their Plan B by restructuring their portfolio holdings or side-pocketing incoming revenues.
If there were ever a time to avoid holding all of the portfolio eggs in a single basket with just one financial institution or liquidity fund, this would be it. Setting up a precautionary liquidity backstop account is a sensible strategy. That’s called belt-and-suspenders risk management.
State treasurers and the managers of local government investment pools will inevitably be asked about their fallback plans to assure liquidity for participating investors in the funds they operate. It’s a pretty sure bet that the commercial money market mutual fund industry will be answering to the Securities and Exchange Commission about its liquidity provisions weeks before the unregulated intergovernmental pools would see a run on the bank.
Will Corporate CEOs Step Up?
All of these issues are likely to surface in the worst-case scenario analysis that could ultimately creep into state and local financial managers’ mindsets. Don’t be surprised if reporters who cover state and local government finance pick up the scent should the debt ceiling brawl reach a brittle impasse on Capitol Hill; it’s a local news angle.
Realistically, however, these doomsday market scenarios seem more remote to me today than the risk of Putin using tactical nukes in Ukraine or the probability of The Big One hitting California this spring. One would expect the adult CEOs on Wall Street to start making calls to congressional leaders to advise them of the runaway fire they are playing with — and the risks to campaign contributions from wealthy donors who have the most to lose from a self-inflicted federal fiscal crisis. In Capitol Hill’s Kabuki theater, the Senate majority leadership will hastily hold hearings that include industry and SEC testimony on the potential impact on retail money market funds.
Ahead of this fanfare, the finance committees of state and local governments should be putting the cash flow issue onto their oversight agendas in the next month. Most treasury investment policies cite the prudent investor rule, which expects their decisions to be made with the judgment and care that a prudent person would use for investment, not for speculation. We’ve now come to a tipping point where speculating on common sense returning to both chambers of Congress any time soon is arguably not a prudent assumption.
Of course, the worst case could dissolve. Hopefully this congressional brinkmanship will all wash away in coming months. And hopefully any risk management measures are just precautions and nothing more. But hope is not a strategy.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
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