The REAL Confidence Fairy

Confidence that the Tea Party GOP won't drive the economy off the financial cliff is what's keeping the markets solvent these days.  The belief that the politicians in Washington on both sides of the aisle will recognize the danger of a default in time for them to come to an agreement is serving to keep things moving in the system.

But any failure to raise the debt ceiling that ultimately results in a Treasury default could spark severe consequences in the crucial plumbing system that underpins global finance, given the central role played by US government bonds.

Treasuries are widely used as collateral for cash loans in the repurchase, or repo, market. On Friday, the Securities Industry and Financial Markets Association held a meeting with staff from the big banks to discuss operational issues that could arise in the event of a default.

Analysts at Bank of America Merrill Lynch estimate 74 per cent of primary dealer repo financing, about $2,100bn, involves Treasury collateral. Money market funds also place significant amounts of cash in the repo market, and a default scenario would create strains for this sector if investors start to pull out their cash.

A downgrade of Treasuries from their triple A or haven status could well ripple through the financial system. “I think people view that as a risk, I know for a fact that we do consider it a risk in terms of all financial assets”, said Rick Rieder, chief investment officer for fixed income at BlackRock.

Modern financial theory starts from the premise that there is a risk-free rate of return available, backed by the “full faith and credit” of the world’s superpower. It is the reference point for pricing other assets.

“In short, we would be back to 2008, but without the US able to bail out the system.”

But the Tea Party GOP doesn't care.