The prospects for ending the federal government shutdown and avoiding a default on U.S. debt remained very fluid Tuesday despite the likelihood that the Senate will reach a deal aimed at keeping the Treasury from going into arrears on its obligations. The continuing resistance to a still-forming deal among Tea Party Republicans in the House make chances for a final agreement uncertain.
Nevertheless, merger industry experts predict only minor short-term disruption to the capital markets if a deal to lift the debt limit isn't reached by Thursday's deadline, which is only a technical deadline anyway. Real long-term damage, however, is possible if talks drag on and the Treasury begins to stop making payments on federal obligations at the end of October, which is when the government's ability to make good on its payments truly begins to get complicated.
David M. Grinberg, chairman of mergers and acquisitions at Manatt, Phelps & Phillips LLP in Los Angeles, said the impact on dealmaking is somewhat unpredictable but can only be negative. "The biggest enemy of deals is uncertainty. If Congress blows through next Thursday without a deal it is certainly going to create uncertainty, which is not a good sign for any market."
The result won't be a complete evaporation of financing similar to the market seizure during the financial crisis of late 2008 and early 2009, but the cost of financing will increase and availability of capital will decrease, he said. "I don't think it will be a total lockup like '08-'09. Deals will still get done. Deals that are ongoing now will continue, but maybe it will be more difficult to start new deals. But the process to get new financing will likely become more difficult, an increase in interest rates might make people less likely to borrow -- right now it's free money."
Grinberg cautioned that a lot of what drives the deal market is psychological and uncertainty can upset the complex combination of factors that creates interest in doing mergers. "Dealflows could drop 25% to 50%, who knows? It's not going to completely fall apart. The fear mongering might be overblown a bit, but people will be inclined to wait it out."
James Cox, professor of law at Duke Law School, said that if no deal is struck by Thursday it will send a shock wave through the financial markets and have a wide-ranging impact on the markets.
"Firms that have a strong currency, they can borrow money from a bank and their strong stock price won't take a hit so much and that will allow them to do deals at better terms" than others, he said.
Duke University law professor Lawrence Baxter said a debt limit default will likely have the greatest impact on big banks. A decline in the value of Treasury securities would likely drive big institutions to post higher amounts of collateral; all of which could rapidly "gum up" the overnight borrowing markets for big banks.
"Essentially this creates the risk of a Lehman-type situation in which all credit becomes frozen," Baxter said. He added that big banks would take a hit to the asset side of their balance sheet, a troubling prospect because of the amount of debt large financial institutions carry.
"Banks are highly leveraged, so seemingly small losses in value can impose suddenly large impairment on capital," he said. He added that large sovereign investors in T-bills, such as China and Japan, will likely take steps to shift their investments to other securities, accelerating the decline in Treasury securities.
All of this can "quickly lead to insolvency and panic in the broader markets," he added.
Baxter added that a failure to raise the debt ceiling would also have a negative impact on big bank capital buffers, which are steadily being put in place after the 2008 crisis. Large financial institutions rely heavily on Treasury securities for their capital buffers because regulators give T-bills a low risk weighting. A default would increase the risk weighting for these securities, pressuring big banks to make other investments to meet capital buffer requirements, a situation that may be difficult to do, he added.
The Federal Reserve Board is working on proposing new rules that could hike the amount of capital required of big banks that rely on short-term funding. Federal Reserve Governor Daniel Tarullo has been calling on regulators to make significant increases in the capital requirements of those that are still substantial users of short-term financing. Recently, he noted that letting banks rely on short-term funding played a big role in the 2008 collapse of Lehman Brothers and Bear Stearns.
Ernest T. Patrikis, partner in the bank and insurance regulatory practice at White & Case LLP, said even a temporary loss of authority to make good on its obligations will cause little short-term disruption, but the longer term effect is likely to be less confidence in the U.S. dollar as the global reserve currency -- a fact that will increase borrowing costs for U.S. companies over the long term.
"Already the short-end of the Treasury market is not very healthy but that will eventually be cured and should not affect the rest of market beyond some effect on rates."
If a short disruption serves to make the public and Washington focus on the country's finances, it might even be a good thing he said.
But Patrikis questioned whether the country's ability to borrow is truly threatened by the talk of default. "The last time the country's debt was downgraded many said that it cost us more to borrow, but I suspect it didn't," he said. "When it's all said, the U.S. is still the U.S. What else are people going to do with their money?"
Over the long term, however, he said that the result of a suspension of the U.S. payments on its debts would provoke investors to increase their holdings of debt from multiple countries because no one country is in a position to replace the U.S. as the major reserve currency.
"It won't happen right away but it's going to erode the role of the U.S. dollar in the world. If the euro wasn't in such horrible shape we'd be dead," he said. "The renminbi is not there yet. But at the margin countries can diversify their reserves, which will make it harder to sell Treasury debt, affect interest rates and accelerate the problem we face with Social Security."
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