A little over two decades ago, something seemingly crazy started in Las Vegas…
Archie Karas decided to drive from Los Angeles to Las Vegas with only $50 in his pocket.
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. He hauled around millions of dollars’ worth of cash and chips in his car, 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 fell for 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 an all too common problem. 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
Friday is the day the government will hit the debt ceiling yet again. The U.S. Treasury Dept. will no longer be able to do much of anything besides collect taxes.
If nothing is done, we will hit an “X date” when the government will default because it cannot pay its bills. The best guess right now is that the government can keep running through late February and potentially into March.
With tax refunds being sent out by the millions during this critical time period, the Treasury will have to deplete its funds at an even higher rate than we saw during the last batch of “extraordinary measures.”
While the government has been able to repeatedly kick the can down the road on this issue, nothing substantial is being done.
Sure, there is a whole lot of other stuff it should be doing too, but nothing is as crucial to the entire nation or world right now.
Politicians can’t seem to put aside a slew of emotionally charged wedge issues. Take your pick between ObamaCare, the Keystone XL pipeline, minimum wage increases, immigration reform, and long-term unemployment benefits. You’ll find plenty of attention for these — but not for the crucial need to pay the bills.
It certainly doesn’t help that Republicans are trying to attach reforms to a debt ceiling increase while Democrats are insisting on a “clean” bill. That worked out so well last time.
Both sides are digging trenches and staring across no man’s land, waiting to snipe anyone bold enough to step out or package damning sound bites into campaign smear ads.
No incentives to rally and overcome exist. Only opportunities to preach to the choir back in their home districts are on their self-serving agendas.
The Nightmare Scenario
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 always get an exception, along with a handful of other no-brainers.
However, there is no way to keep everything in order, and numerous obligations will not be met. Social Security, disability, and national debt interest payments cannot all be made.
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.
Last year, the shutdown was short enough that the Treasury just squeaked by without an issue.
Proposals have been made to let it prioritize some payments over others, but there is no system in place to actually accomplish this kind of triage.
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.
It is the secondary effects from these two consequences of default that are less obvious but utterly catastrophic.
The Role and Risk of Shadow Banks
Modern finance is incredibly different than it was in 1979 due to the rise of shadow banking.
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 $1.5 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 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…
However, a credit crunch from a government default would be worse than what we experienced in 2008. Instead of bad bets on poorly explained and toxic mortgage-backed securities, the underlying currency of the financial system — U.S. Treasury bonds, which fuel the entire global finance system — would be the cause.
Contagion wouldn’t just be a concern. It would be instantly guaranteed across all sectors and nations.
Inevitable Market Crash
Investors and the major institutional players in the market went into the October 2013 budget and debt ceiling situation absolutely sure that politicians wouldn’t let the government default. They fell for the same “hot hand” logical fallacy as politicians, and they’re doing it again.
That can (and will) change if the deadline approaches without a deal in place and without legislation progressing through the government.
Taking a look at what happened in the summer of 2011 will give us a good idea of how the market will react when its expectations aren’t met.
A debt ceiling crisis was averted on the final day before default. The aftermath continued to play out for weeks as the markets reacted to a credit downgrade for the nation and the aftershocks that rippled across the globe.
From July 22, 2011 to August 8, 2011, the S&P 500 shed 222 points. The drop from 1,345.02 to 1,119.46 represented a 16.77% dip.
The partial shutdown in October of last year led to a 7.5% drop in the S&P 500 before the markets rallied on news of bipartisan agreement.
Through February, it is likely we’ll see something similar… but with worse consequences.
The S&P 500 is down 5% since the year started. It has smashed through resistance at the 20- and 50-day moving averages, and technical traders are starting to get itchy trigger fingers for three reasons:
- Around 1,730, the S&P 500 will hit the 150-day moving average support level, an intermediate trend barrier.
- Near 1,705, it will pass the 200-day moving average, triggering indiscriminate selling across the board.
- If the S&P 500 doesn’t meet strong resistance and sheds 7.5% like it did last time we faced this absurd scenario, we could see the index down around 1,624 and the start of a long-term bear market.
We can also expect a large dent in GDP figures. Halting government spending alone has the potential to halve quarterly economic growth. Corporate spending, consumer sentiment, unemployment figures, house purchases, manufacturing, and wages will all get slammed.
If the government defaults, there is no doubt economic growth will quickly go negative and potentially cause another recession as it lingers for several quarters.
As the clock ticks, the only people who can do anything to prevent this catastrophic system failure are doing nothing. They are blindly assuming their winning streak will continue.
Their procrastination and complacency threatens the entire world… and there is very little time left to make up lost ground and steer away from disaster.
