As the threat of an unprecedented default in U.S. government debt plays out over the coming months, the United States is in uncharted territory.  And so are directors and management teams at corporates, whether public or private.  While there have been a number of actual and threatened “government shutdowns” in recent years, and government agencies and executives have experience navigating them, a market perception of a credible default risk on U.S. debt (even short of an actual default) would be a new scenario for which no one has a playbook.  But parts of the financial markets are beginning to notice in small ways the lack of legislative progress^[1] and the broader financial markets may react in the coming months with implications for corporate capital raising, liquidity and risk management.

For companies that depend on functioning capital and loan markets for liquidity, it’s time for planning—both for potential dislocations that may come if investors and lenders begin to perceive a credible risk of a default, and for the shocks that will come if a default, previously unthinkable, actually happens.

While this memo offers directors and management teams some thoughts on actions they may wish to take, to be clear, it’s our strong view that politicians on both sides of the aisle have a responsibility to the country to resolve the debt ceiling impasse promptly and before the country and the economy are harmed.  We hope they will do so and make this alert memo irrelevant.

We’ve Seen Shutdowns Before—but Not Debt Defaults

In recent years, the U.S. government has shut down a number of times because Congress didn’t authorize appropriations of cash. When this happens, the U.S. government has an authorization problem, in which cash is available to be spent, but Congress has failed to authorize the spending.  This is an appropriations lapse scenario.

In an appropriations lapse, the government “shuts down” but continues to pay its debt, and has a playbook for conducting itself day-to-day.  In fact, there is a statute, the Antideficiency Act, 31 U.S.C. § 1341, which restricts the conduct of government agencies by prohibiting agency heads and their employees from making or authorizing expenditures in excess of appropriations but allows some essential activities to continue.  Moreover, several government agencies, including the Securities and Exchange Commission,^[2] have operations plans in place that come into play during an appropriations lapse and resulting government shutdown.  These plans lay out in great detail which of the agencies’ activities will continue and which will not (for example, in the SEC’s plan, EDGAR support and lines for investor complaints remain open, but approvals of registration statements and staff training stop).

By contrast, if Congress doesn’t raise the “debt ceiling,” as the legal cap on how much the federal government can borrow is known, the U.S. government will have a liquidity problem.  This is a default scenario.  In a default scenario, Congress has previously authorized spending (to pay employees, repair roads, pay interest on the government’s debt and so on) but, the government can’t borrow and doesn’t have enough tax revenue to pay for those things, and eventually the Treasury Department would be forced to default on its bonds.  In order to avoid that scenario, congressional Democrats and Republicans need to reach an agreement to raise the debt ceiling.  On April 17, 2023, Speaker Kevin McCarthy proposed a one-year increase of the debt ceiling in exchange for a series of budget cuts, whereas President Biden has repeatedly proposed that Congress raise it without conditions and address budget negotiations separately.

The United States is no stranger to debate over whether to increase its debt ceiling.  The debate has been had in Congress dozens of times following the statutory imposition of the limit in 1917.  It has now re-emerged after the federal government reached its $31.4 trillion debt ceiling on January 19, 2023.  The  Congressional Budget Office estimates that the United States risks defaulting on its debts as early as July (though it has also noted that “extraordinary measures” the U.S. Treasury Department has put in place may forestall a default until as late as September), while others have suggested June is more likely.^[3]  More recently, Goldman Sachs analysts suggested that weak tax collections so far in April indicate a higher probability that the debt limit deadline will be reached in the first half of June.^[4]

So, while the timing of a government shutdown is somewhat predictable, the timing of a debt ceiling crisis is far less clear, and will depend on when the federal government exhausts the “extraordinary measures” that have been put in place to continue paying its obligations.  While markets so far have not reacted strongly to the possibility of a debt default in the future, at some point they may take it more seriously—and when that will be is difficult to predict.

Adding to the uncertainty, there is no blueprint defining how government agencies will proceed if the U.S. defaults on its debt obligations, particularly since past budget negotiations have always ended in the debt ceiling being raised or suspended.

There isn’t any formal guidance about the effects of a debt ceiling crisis on government operations.  The most detail that we could identify is a letter that the Treasury Department sent to then-Senator Orrin Hatch detailing some of the options it considered to address a potential default during the debt ceiling crisis of 2011.  The letter indicated that it had considered “asset sales; imposing across-the-board payment reductions; various ways of attempting to prioritize payments; and various ways of delaying payments.”^[5]  The letter does not indicate how Treasury would have implemented those options, but it does note that Treasury officials “viewed the option of delaying payments as the least harmful among the options under review.”

What Corporates Should Do

Given all of the uncertainty about when the U.S. government could default and how and when markets will begin to react, we would suggest taking some steps now, both to address future market dislocations and an actual default.

Steps to Address Nervous Markets Anticipating a Default

1. If markets begin to perceive a credible risk of a default, interest rates may spike; corporates with short-term funding needs may wish to access the market sooner than they otherwise would in order to pre-fund ahead of a potential spike.
2. Consider whether it is preferable to fund at fixed rates rather than floating rates (or hedging your floating rate loans) to help mitigate the risks associated with interest rate volatility.
3. For SOFR-based floating rate debt, we may see an increase in SOFR, because SOFR is calculated based on transactions in the repo market with U.S. treasuries as collateral.
4. For corporates that access the U.S. public markets but that do not have a shelf registration statement in place or that may exhaust the capacity of their shelf registration statements in the months to come, consider placing a new shelf registration statement on file.Given the potential uncertainty around whether, and the extent to which, government agencies will be operating, having an existing shelf registration in place will maximize the possibility of being able to issue debt even if the SEC is unable to declare registration statements effective.
5. We recommend that corporates begin to discuss contingency plans for a U.S. government default with their boards of directors.Corporates may also need to consider whether to disclose these contingency plans and the nature of their board of directors’ oversight of such plans in their periodic reporting.
6. If a default occurs, the economy is more likely to experience a recession or a recession may occur sooner than it otherwise would have.Management teams may want to review their operational plans addressing recession risks to ensure that those plans (including the base case scenario) remain appropriate, particularly in light of a given company’s industry and recession exposure.
7. A spike in interest rates in anticipation of a default could exacerbate lingering concerns about the banking sector in the aftermath of Silicon Valley Bank’s collapse, particularly the risks of uninsured deposits.While corporates can be expected to evaluate their exposures to banks as uninsured depositors, the FDIC’s invocation of “systemic risk” to protect uninsured depositors in the failures of Silicon Valley Bank and Signature may result in more stable uninsured deposits, at least in the near term.
8. Corporates should review their bilateral swap contracts to determine whether they include any requirement to deliver more or different margin collateral if the US is downgraded or treasury securities are downgraded or in default.

Steps to Address an Actual Default

1. Consider establishing or expanding your options to borrow in non-dollar currencies through non-U.S. lenders.If a U.S. default occurs, it’s difficult to predict the impact on global markets; however, the ability to borrow in non-dollar currencies may prove useful.
2. Corporates holding investments in money market funds investing in short-term Treasury bills may face increased risks in the months to come, as the Treasury Department may stop paying those bills during a default.As a result, money market funds may be unable to provide cash upon redemption of those funds.  Corporates may need to consider whether to move their investments into funds investing in longer-term Treasury bills, into direct investments in longer-term Treasury securities, or into instruments of other highly-rated obligors, such as foreign-denominated bonds, municipal bonds or corporate bonds.

ENDNOTES

[1] “Debt Ceiling Jitters Drive Up Cost of Insuring against US Default,” Financial Times (April 13, 2023), available here.

[2] See here.

[3] “Federal Debt and the Statutory Limit, February 2023,” Congressional Budget Office (February 2023), available here.  Estimates of the timing of a potential default vary, with U.S. Treasury Secretary Janet Yellen having warned of a default risk to come as soon as early June.  “Yellen Warns of U.S. Default Risk by Early June, Urges Debt Limit Hike,” Reuters (January 13, 2023), available here.

[4] See “U.S. Debt Ceiling Deadline Could Be Sooner Than Anticipated, Banks Warn,” U.S. News & World Report (April 18, 2023), available here.

[5] See here.

This post comes to us from Cleary Gottlieb Steen & Hamilton LLP. It is based on the firm’s memorandum, “Corporates Face Novel, Greater Risks from Debt Ceiling Impasse—Even if No Default Occurs,” dated April 25, 2023, and available here.