As you all know by now, there’s a chance that the Federal government will be shut down as of midnight tonight due to lack of authority to fund it. This lack of authority comes from the fact that there is no budget and the law that allows Congress to temporarily continue to spend without a budget (known as the Continuing Resolution) is expiring. Just to be clear, markets continue to provide the Federal government with virtually any amount of financing they want/need to run the country. Obtaining money IS NOT an issue. This shutdown would be strictly due to Congress’s inability to pass a law to permit themselves to continue to spend money. It really is silly, no matter what side of the aisle one supports, but it’s the way our country works.

I’m not as confident in this getting resolved in time as I was in the Fiscal Cliff getting resolved at the 11th hour last year. However, here we’re not talking about laws that would dramatically change without action as we were with the Fiscal Cliff. We’re talking about the Federal government’s ability to perform its non-essential tasks temporarily. They’ve already indicated that all essential tasks, including those related to public safety, will go on even without a Continuing Resolution. The government has shut down numerous times in the past with negligible impact (to the point that most people don’t even remember the prior shutdowns). As long as a Continuing Resolution is passed at some point in the next few days or even weeks, there will be little to no lasting impact beyond the clear demonstration to the world, to businesses, and to individuals that our government has become inept.

Coming up shortly after this Continuing Resolution debate will be the Debt Ceiling debate. On or around October 17th, the Treasury will hit the current legal debt limit and will be unable to borrow money to fund the operation of the government and, more importantly, to make interest payments on its outstanding debt. Again, a government shutdown probably wouldn’t have a big impact as long as it only temporarily impacts non-essential services. Missing an interest payment, however, would have serious ramifications to the economy and global financial markets. In the order of increasing impact hitting the Debt Ceiling would:

• Threaten the full faith and credit of the United States as lenders may consider the fact that we don’t make timely payments on our debt and may hesitate to lend us money in the future or demand higher interest rates in order to lend that money. I’d say this is a fairly small issue overall, as the U.S. Dollar / U.S. Treasuries are still going to be considered the strongest and safest place to put money.
• Indicate how dysfunctional our government has become when it comes to problem solving, perhaps threatening confidence in U.S. growth and long-term solvency, especially considering the fiscal issues that need to get resolved in the coming years (Social Security and Medicare for example). This could definitely has some impact over our ability to borrow at low rates in the future.
• Mean a technical default on our debt. While this seems the most trivial of all, especially knowing that it would only be temporary, this is the biggest issue because of all the derivative securities like credit default swaps (CDS) that are outstanding on U.S. debt. CDS are essentially insurance contracts that state that if a particular debt instrument defaults, the CDS would pay out a fixed amount as insurance against that default. A default on US Treasuries that is caused by a missed interest payment, no matter how temporary and technical in nature, would likely trigger at least some of those contracts to pay out. CDS are a highly unregulated part of the financial markets and there’s no telling how many of these contracts have been written and who’s on the hook for making payments in the event of a default. It is highly likely that some financial institutions would have to make large enough payments that they could fail. This is virtually the same problem that occurred with the ’07-’08 financial crisis and could result in a repeat of fallout we saw from Bear Sterns, Lehman, and AIG falling apart at that time.

Because of the severity of the impact of hitting the debt ceiling, it’s obviously a much bigger issue than the government shutdown that may begin tomorrow. Markets have started to react. They are pricing in the fair probability but relatively small effect of a government shutdown. They’re also starting to price in the very low (but not zero) possibility of hitting the Debt Ceiling in a few weeks (if we can’t solve the simple issue of the Continuing Resolution, it must mean that there’s an increased chance of not being able to solve something more complicated like the debt limit… that’s how the markets look at this). Regardless of what happens tonight, tomorrow, and in the coming days around keeping the government running, I’m very confident that the debt ceiling issue will be resolved in some manner without a default. Market will be volatile (down and up) over the next few weeks. A game of chicken in Congress will develop. Nothing will get resolved until it absolutely has too. Those are virtual certainties. What’s also certain, despite what the media will present over the next several hours, is that life will go on tomorrow with or without non-essential services from the Federal government.

Congress needs to get its act together. However, it doesn’t need to do it tonight. That lack of urgency, despite media representations, is what very well might prevent them from getting it together tonight. High media interest in something that really isn’t a crisis is the perfect opportunity for grandstanding and that’s what it looks like we’re getting.