Catastrophic System Failure

Why Default is Far Worse than You Realize

Written by Adam English
Posted September 13, 2013

A little over two decades ago, something seemingly crazy started in Las Vegas. And to this day, nothing else has come close to it...

Archie Karas decided to drive from Los Angeles to Las Vegas with only $50 in his pocket. What would come to be called "The Run" was about to shock everyone.

In six months, Karas' $50 became $17 million. In three years, he'd won more than $40 million.

He beat some of the world's best poker players and pulled in over a million playing pool at $40,000 a game. It got to the point where people wouldn't even play him because the stakes were too high.

Karas hauled around millions of dollars' worth of cash and chips in his car. He bought a gun and had to have casino security guards escort him around town.

And then Archie Karas lost all of his money in just three weeks.

$20 million disappeared in dice games... $3 million in poker games... and $17 million at the baccarat tables. After a trip to Greece, he returned and lost another $12 million. He wasn't done, though...

A few years later, Karas turned $40,000 into $5 million — then lost it all the next day.

Karas made the classic mistake we all make, unless we maintain a cold and calculating view. People call it "the hot-hand fallacy." It is the belief that a person or group that has been successful in a series of random events has a greater chance of continued success.

This is a fundamental problem with the human brain. If the outcome of an event is consistent, it is incredibly easy to start ignoring the random and chaotic nature of it. We start acting like the odds are better than they are, and we think there is some level of control we can maintain.

Our politicians should be thinking about Archie Karas right now. They are complacent. They assume their previous success will continue, in spite of the odds stacked against them. They're in a high-stakes game that can strip away everything we've regained since the Great Recession, and they aren't even paying attention to the cards they have been dealt.

Distractions and Diversions

October 18th is the projected date when the government hits the debt ceiling and the U.S. Treasury Dept. will no longer be able to do much of anything, besides collect.

While the government has been able to repeatedly kick the can down the road on this issue, there is a whole lot of other stuff it should be doing but cannot seem to handle. Gridlock is worse than ever, along with the issues distracting everyone...

Syria is hogging the limelight, and the divisive issue is not going to end any time soon. Republicans cannot resist the urge to weaken President Obama by making sure he fails all attempts to rally Congressional support for military strikes.

Diplomatic efforts will take up a lot of time, along with hearings, interviews, and other attempts to grab media attention.

The same goes for the ongoing revelations about the NSA's blatantly unconstitutional surveillance. The latest round shows the NSA has been in direct violation of FISA court rulings. It's easy pickings for any politician who wants to pontificate to hide the fact that they are complicit to the whole mess.

Both issues also highlight how the leaders of the parties are unable to keep their colleagues in line with mainstream party positions.

Obama is completely incapable of rallying Democrats behind strikes in Syria; and sending administration officials to lie to Congress regarding the NSA issue isn't exactly inspiring confidence or loyalty.

Rep. Boehner has it even worse. His fellow Republicans have consistently ignored his lead and inspired countless articles questioning how long he can last when he has no legitimate leadership role. He represents the Old Guard in a decentralized party that is reinventing itself.

Just look at how this is affecting sequestration, immigration reform, and a direly needed farm bill that can't gain momentum...

Sequestration was barely modified at all, even though everyone wanted to avoid it or change it.

Immigration reform, in spite of the most promising window in a decade, went nowhere and is effectively dead in the water.

And then there's the farm bill: Two competing versions have passed, but there is virtually no hope of bridging the partisan divide over the liberal-sculpted Senate version and its more conservative version from Congress.

Contentious tweaks to food stamps and direct farm subsidies are jeopardizing hundreds of programs, many of which are non-issues, and the Senate almost used the "nuclear option" to end filibusters just to get a vote on a handful of executive appointees when hundreds still languish.

In both the Senate and Congress, different issues are being linked together in spite of their independence: Syria and ObamaCare are tied together; sequestration and the farm bill are linked through military spending modifications.

A colossal web of contingencies is creating "all or nothing" partisan positions, when the right path to take is to divide and conquer.

However, there are no visible attempts to push to a middle ground. Both sides are digging trenches and staring across No Man's Land, waiting to snipe anyone bold enough to step out.

No incentives to rally and overcome exist, leaving everyone to preach to the choir back home and throw their peers under the bus in the hopes of not being worse than their opponent in the next reelection.

The Unintended Consequences

A couple effects of hitting the debt ceiling are blatantly obvious...

 

First, the government will stop sending out any form of payment unless exceptions are made. Military paychecks and such are likely safe, but numerous obligations will not be met, such as interest payments. 

Back in 1979, when Congress barely passed a compromise to increase the debt limit, the U.S. Treasury actually couldn't respond in time to get all of the checks out... In the end, it simply repaid what was due with interest.

The second obvious effect is a halt to bond issuance by the U.S. Treasury. It can't take on new debt when it hits the maximum allowed by law.

The secondary effects from these two consequences of default are less obvious, but utterly catastrophic.

Modern finance is incredibly different than it was in 1979 because of the rise of shadow banking.

In the muddled world of high finance, many of the big players aren't banks, but they act just like them. Hedge funds, structured investment vehicles, insurance companies, pension funds, and money-market funds all borrow on the short-term and lend money out on the long-term.

These shadow banks don't have FDIC coverage or access to the Fed discount window. Without access to short-term loans from the Fed, they use repurchase agreements (or repos) to create liquidity. This means a lot of collateral is changing hands all the time to mitigate risk.

In spite of recent history, Treasury bonds are still highly-coveted as the best and easiest collateral to use. About $2.8 trillion in Treasury bonds are being used as collateral in these repo deals right now.

If and when they default because the Treasury cannot make any payments, all hell will break loose.

Virtually all of the shadow banks rehypothecate the collateral to add leverage and potentially pull in more profits. That means that there is far less than $1.5 trillion worth of Treasury bonds to fulfill the collateral agreements.

Default would cause entire webs of contracts to fail. No one knows who is entitled to what when the paper agreements don't match the bonds that actually exist. Legal fights over the assets would tie everything up. What's more, credit worthiness and liquidity would disappear overnight.

No one wants to make the short-term loans that the entire corporate world uses to make interest payments, cover weekly payroll, and keep the lights on.

The credit crunch from the Lehman Brother collapse would reappear overnight, and we'd be on the brink of worldwide system failure yet again.

However a credit crunch would be worse now than it was in 2008. The Fed is sitting on nearly $3 trillion of extra U.S. debt. The economy cannot lose any growth without slipping into recession.

Workers are making less than they were five years ago, and have virtually nothing saved...

The 76% of Americans living paycheck to paycheck would be immediately exposed to eviction, hunger, and empty gas tanks, if their paychecks bounce.

As the clock ticks, the only people that can do anything to prevent this catastrophic system failure are doing nothing — except blindly assuming their winning streak will continue.

Their procrastination and complacency threaten the entire world... and only 20 days remains while Congress is in session to change this course.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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