In a blog posted this week, Jack M. Guttentag, professor of finance emeritus at Wharton, warned of the consequences — both immediate and long-term — of a debt default by the federal government. Asked by Knowledge at Wharton what continues to be the single biggest obstacle to agreement on a plan to increase the debt ceiling, he responded — “an ideological gridlock between different political forces that may be playing a game of chicken to see which one is going to blink first to prevent a catastrophe. To put the country through this horror in the expectation that someone will blink and everything will come out all right is just unbelievably irresponsible.”

One low point of the ongoing debate is a realization that the U.S. Treasury “has no mechanism for making decisions about the allocation of funds when they become scarce,” Guttentag added. But at some point, the government must figure out who gets paid. “God knows how those decisions will be made.”

Below is Guttentag’s take on the current gridlock over the debt ceiling.

“How would a debt default by the Federal Government impact the home mortgage market?”

We can only guess about the extent of the impact, but it would range somewhere between ugly and catastrophic. Ugly might be a doubling of interest rates and a drop of 50% in loan volume. Catastrophic would mean an almost complete shut-down.

About 95 of every 100 home loans being written today are placed into mortgage-backed securities that are sold in the market with guarantees by Fannie Mae, Freddie Mac or Ginnie Mae. These are federal government guarantees, the value of which would drop like a rock with a default.

At best, the securities market would immediately demand a sizeable rate premium on new guaranteed mortgage-backed securities to compensate for the added risk. This would immediately translate into sharply higher interest rates charged to new borrowers.

At worst, the markets for these securities would stop functioning altogether as investors retreated to the sidelines to await further information on which government obligations would be honored and which would not. That could be a long wait, since the systems the government uses to make payments have no provisions for allocating funds when there isn’t enough money to pay all claims, and there are no contingency plans for this [situation]. 

“If a default had the horrendous consequences you describe, and these induce Congress and the Administration to agree finally on an increase in the debt ceiling, how long would it take financial markets to return to normal?”

Markets would never return to a state where U.S. Government obligations are viewed as riskless. We will pay for this loss of grace forever.

Investors in fixed-income securities are worse-case oriented, and make a major distinction between the impossible and the unlikely. The current rates that the Treasury must pay investors are based on the assumption that default is impossible. Once a default occurs, it will never again be viewed as impossible. The additional cost of carrying debt on which default is possible will be paid forever.

“How much extra would it cost?”

That is not knowable in advance, but I’ll hazard a guess. My guess is that the cost of carrying the federal debt will increase by about 3 percentage points where it would more or less match the return on investment grade corporate bonds. On a debt of $14 trillion, an increase of 3% in carrying cost would add about $420 billion to our annual deficit.

 An optimistic estimate would be that the cost would rise by only .25%, which would increase the annual deficit by “only” $35 billion.

“Do you really think there will be a default?”

Given the current political impasse, I think the probability is frighteningly high. The message I drew from [this week’s] address by President Obama and the follow-up comments of House Republican Speaker Boehner is that both were more heavily invested in their positions on spending and taxes than on the need to avert default. 

Many important events, especially in the political world, are the result of inadvertence. Nobody planned them, often nobody wants them, but events set in motion years earlier acquire a momentum of their own and nobody has the motivation and/or power to stop it. Since nobody wants it, everybody expects someone else to swing the axe.

In that connection, the threat posed to mortgage lenders, realtors and home builders by a debt default is enormous, but where are their spokespersons? When a bill is introduced to, e.g., eliminate tax deductibility of mortgage interest, the trade groups are all over the Congress and Administration to beat it. But on an issue that threatens their very existence, they are nowhere to be seen. Their assumption seems to be that at the 11th hour the politicians will prefer doing the right thing to laying the blame for disaster on their adversaries. In the current political climate, that is a terribly risky assumption.