Duke University Law School’s Steven L. Schwarcz sent me the draft of his new paper, back in September, but the semester was just getting underway, and in any case, it seemed to me then that a paper titled “Rollover Risk: Ideating a U.S. Debt Default” was referring enough to a possible world that I could wait a few weeks to comment. A few weeks later, the world Steve describes suddenly seems much closer, and I recommend it to you for a sober, serious commercial and finance law professor’s take on how default might occur, avoiding it, consequences, and ways of mitigating consequences. The paper makes a core observation that illiquidity risks are different from insolvency risks, though the former can lead (quickly in some instances) to insolvency, as was seen in the 2008 financial crisis. The illiquidity risk that the US government faces is particularly that of roll-over risk – financing long term commitments by borrowing at short term and rolling the debt over continually. Again, as seen in the 2008 financial crisis as well as in the European bank and sovereign debt crises that arose later. “Roll-over risk” is the possibility that suppliers of credit in the debt market might decide not to roll over the existing debt, instead taking repayment but not re-lending, even at some higher interest rate.
Here is the abstract at SSRN. I highly recommend the paper, particularly to policy wonks, think tankers, and financial journalists who might want to learn how the consequences of even a “technical” default could become important. The starting point for understanding roll-over risk in this context is that the US government, as the article explains, relies very heavily on short term debt – it has to “roll over half of its debt every two years … It recently was estimated that the U.S. government would have to roll over seventy-one percent of its privately-held debt over the next five years.” The article does not seek to estimate the likelihood of the US government suffering a “technical” default, nor does it attempt to assess the politics of debt ceiling strategizing between the political parties, but instead asks what would happen and what it would mean if a default were to occur.
This article examines how a U.S. debt default might occur, how it could be avoided, its potential consequences if not avoided, and how those consequences could be mitigated. To that end, the article differentiates defaults caused by insolvency from defaults caused by illiquidity. The latter, which are potentiated by rollover risk (the risk that the government will be temporarily unable to borrow sufficient funds to repay its maturing debt), are not only plausible but have occurred in the past. Moreover, the ongoing controversy over the federal debt ceiling and the rise of the shadow-banking system make these types of defaults even more likely today. The article also examines how a U.S. debt default could be avoided, discussing steps — including monetizing debt and printing money to pay maturing debt — that the government could take to facilitate debt repayment, as well as limits on the government’s ability to avoid defaulting. The article then examines the consequences of a U.S. debt default, demonstrating that even a temporary default caused by illiquidity would have severe economic and systemic consequences, significantly raising the cost of borrowing and causing securities markets to plummet. Such a default would also raise a host of legal issues, including constitutional questions of first impression under the Fourteenth Amendment. Finally, the article explores how the negative consequences of a default might be mitigated, potentially through a debt restructuring or even a possible IMF bailout.