Special Report: The Debt Ceiling 'Nightmare Scenario' Explained

A little over two decades ago, something seemingly crazy started in Las Vegas...

And to this day, nothing else has come close to it.

What would come to be called "The Run" was about to shock everyone.

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. 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

The U.S.A. debt limit deal passed last year authorized a suspension to the limit through March 15th, 2015. After this date, The U.S. Treasury Dept. can no longer do much of anything, besides collecting taxes and using some accounting tricks.

If nothing is done, we will hit an "X date" where the government defaults because it cannot pay it's bills.

Through some accounting tricks, the Treasury Dept. estimates it can keep the government running into October or November.

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...

ObamaCare is still hogging the spotlight. Congressional Republicans are adamantly sticking to demands that the unpopular law be delayed or defunded.

Meanwhile, a case over semantics has put subsidies that are essential to the health care law in limbo until the Supreme Court weighs in.

If the current ruling stands, there is no replacement or plan to wind down the current system, and the economic effect will be unpredictable except for how chaotic it will be.

President Obama was a lame duck president facing Republican majorities in the Senate and Congress. These majorities are not veto-proof, guaranteeing showdowns over virtually every issue.

Then there is the minimum wage debate, renewed interest in immigration reform, long-term unemployment benefits, etc.

All of these issues highlight how leaders of the parties are unable to keep their colleagues focused on the most basic functions of government.

Partisan wedge issues are not being addressed on their own. A colossal web of contingencies is creating "all or nothing" proposals that will never pass the House and Senate, 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 seen as worse than their opponent in the upcoming mid-term elections.

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 and such will be sent out. When we've hit the debt ceiling in the past, this has never been an issue.

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 having to pick and choose what to pay. 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.

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

In the muddled world of high finance, many of the big players aren't banks. They act just like banks though.

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...

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 cause of the crunch won't be bad bets on poorly explained and toxic mortgage-backed securities. It will be the underlying currency that fuels the entire global finance system. Plus the Fed is sitting on about $4 trillion of extra U.S. debt and has little to no capacity to take on more of a debt burden or stimulate growth any further.

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, if they are furloughed and are not paid, or if they are laid off from the private sector fallout.

The roughly 63 million people on Social Security, 48 million collecting food stamps, 50 million on Medicare, and 4 million on Medicaid will lose vitally important income and benefits. Virtually all of this money keeps these people alive.

Inevitable Market Crash

The market coasted through the budget deadline without much of a reaction. Stocks, on the whole, did not react as they had in the past. Investors and the major institutional players in the market went into the situation absolutely sure that politicians wouldn't let the government default...

Yet, that can (and will) all change as the deadline approaches.

Taking a look at what happened in the summer of 2011 will give us a good idea of how the market will react...

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% drop.

debt ceiling drop Aug 2011

The partial shutdown in October 2013 led to a 7.5% drop in the S&P 500 before the markets rallied on news of bipartisan agreement.

Without legislation being passed by late summer, we can expect something similar to occur if politicians do not act to fulfill the government's obligations — wiping out trillions of dollars.

This will almost certainly create a steep drop in the markets that will be difficult for investors to climb out of just to post positive gains for the year.

We can also expect a large dent in GDP figures. The government shutdown alone has the potential to halve quarterly economic growth if it goes right up to the deadline.

Corporate spending, consumer sentiment, unemployment figures, house purchases, manufacturing, and wages will all get slammed.

If the government defaults, there is no doubt that 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 threaten the entire world... and there is very little time left to make up lost ground and steer away from disaster.

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