May 26, 2023
by Stephen Foerster | Medium.com
For decades I’ve been telling thousands of business school students that U.S. Treasury bills and notes are risk-free. Well, that’s arguably not quite true. For example, in 1979, Mrs. Claire Barton, a small investor from Enrico, California tried to signal to the world that the U.S. Treasury had stiffed her and others. She sued and wanted compensation, in a largely-forgotten David (or rather Claire) versus Goliath story. Her case was dismissed “with prejudice” which barred her from refilling her claim. It’s easy to understand why her case is largely forgotten. In 2011, the National Archives and Records Administration destroyed all of the case records. But 1979 wasn’t the first time the U.S. had arguably defaulted.
Why does this matter now? In 1917, Congress placed restrictions on how much money the government can borrow. The debt ceiling has since been raised 78 times. Every time a debt-ceiling game of chicken plays out among politicians, like in 1995, 2011, and 2013, investors and credit rating agencies are on high alert, wondering what might happen with a default. Investors get nervous and demand higher yields. That costs the government more money to borrow. And it costs it its reputation as a safe haven. Let’s review the case for claiming the U.S. is actually already a serial defaulter.
Before we recount the default stories, we need to start with what we actually mean by default. According to the Merriam Webster dictionary, to default is defined as “to fail to fulfill a contract, agreement, or duty, such as to fail to meet a financial obligation.” Default generally is derived from contract law when terms of a private contract are violated. For example, if a firm borrows by issuing a bond and then fails to make scheduled interest or principal payments, then it is deemed to have defaulted. In such a case, the party that has been damaged can sue to either compel the other party to perform as agreed, or to seek some other remedy.
Sometimes it isn’t crystal clear when a default has actually occurred. Default can depend on judgment. For example, there are derivative products called credit default swaps (CDS) that allow investors to offset or swap credit risk. A lender might buy a CDS from another investor who agrees to reimburse them if the borrower defaults. A committee organized by a swap and derivatives organization determined when a “credit event” or default has occurred, for the purposes of the CDS contract.
When it comes to contracts, no contract can anticipate every possible event and specify a contingency. There will always be grey areas. That’s why we say that every contract is incomplete. And that’s why in the history of the U.S., whether there have been defaults is still debated. Here are a few examples, as described by Andrew Austin in a thorough and excellent Congressional Research Service report, suggesting there have already been several defaults.
The War of 1812
War between the U.S. and Great Britain broke out in June 1812 and lasted until February 1815. The war is famously remembered for British troops burning both the Capitol and White House in 1814. (And it was known as the White House before it was burnt, first covered with lime-based whitewash in 1798.) Historians claimed that while Americans mismanaged the war militarily, they also mismanaged it financially. It didn’t help that in 1811 Congress had failed to renew the charter of the government’s fiscal agent, the first Bank of the United States. The result was the fragmentation of governments operations — by the start of the war the government had deposits in 21 local banks.
By mid-1813, the government wasn’t able to borrow on reasonable terms. President Madison called upon Congress to find new sources of revenue. Congress was able to find $5 million in revenue sources and allowed the Administration to borrow $7.5 million. But by early 1814, borrowing rates were extremely high and both American banks and European markets refused to lend to the U.S. government. By August 1814, payment in gold or silver was suspended in most of the U.S. outside of New England, which meant that bank notes in one state weren’t accepted in other states. By this time the Treasury department had accounts in 94 banks.
In October 1814, Alexander Dallas became Treasury Secretary. He noted in a letter the “embarrassment” the Treasury was suffering and that “the dividend on the funded debt has not been punctually paid; a large amount of treasury notes has already been dishonored.” As an example, on October 1, 1814, Boston investors weren’t paid interest on federal debt that was owed to them, and they refused to accept Treasury notes as payment rather than gold or silver. This was a clear case of default. It wasn’t until the end of the war that finances improved.
Roosevelt Goes Off the Gold Standard
The U.S. has had a long monetary history associated with gold. After the Constitution was ratified in 1789, U.S. currency — paper and coins — could be redeemed for gold. There were some lapses, including around the War of 1812 as well as the Civil War, but eventually the U.S. returned to the gold standard. In the early 1900s, some Treasury securities contained specific clauses indicating that both interest and principal would be paid in “U.S. gold coin of the present standard of value.” Many felt at the time that the Treasury would have needed to pay higher interest if that clause wasn’t included.
Then came the Great Depression. Between 1929 and 1933, almost 10,000 banks out of 25,000 failed. This was before deposit insurance and so bank runs were common. To try to quell the runs, several states imposed bank holidays to allow banks time to restructure. One such holiday occurred in New York in 1933, the morning of Franklin Roosevelt’s inauguration.
Over the next year, a number of laws were passed to resolve the banking crisis, many of which had to do with gold. To end the immediate banking crisis, trade in gold bullion was suspended. Congress then passed the Emergency Banking Act that gave Roosevelt the power to control international and domestic gold shipments. Then the gold standard was suspended, decoupling the dollar’s paper currency from its previous link to gold. A law was passed that reduced the gold content of a dollar by half. Congress then passed a resolution that rescinded any gold clauses in both private and public contracts.
The cancellation of gold clauses led some investors to sue the U.S. government. Investor John Perry was one of them. He bought $10,000 of Liberty gold bonds that were payable in “gold coin of the present standard value.” At the time a dollar was deemed to contain 25.8 grains of gold. But when Perry redeemed the bond, the standard had fallen to 15 5/21 grains. So he sued, claiming he was owed the original amount of gold.
In 1935, in a 5–4 decision, the Supreme Court upheld that Congress had the power to regulate the value of money, but by attempting to override the obligation in the bond Perry owned it went too far. However, the Court claimed bondholders weren’t damaged because even if they had been paid in gold, they would have been forced to sell the gold at the price set by federal regulations. Dissenting Supreme court justices were less kind in their assessment, claiming Congress had schemed to destroy private obligations and repudiate national debts.
The 1979 Mini-Default
In late-April and early-May of 1979, the Treasury delayed some payments, mainly due to back-office and organizational problems. The Bureau of the Public Debt was automating its processes while the U.S. Treasury’s word processing system unexpectantly failed. Other factors contributed to the delay. The result was that about 4,000 Treasury checks for interest and principal payments held by individual investors worth $122 million weren’t sent on time. The foregone interest because of the delays was estimated at $125,000. By mid-May, check processing was back to normal.
At the time, the U.S. government didn’t have any mechanism in place to compensate investors for payment delays. And so Claire Barton, who was represented by her husband who was an attorney, filed a class action suit against the government. The suit alleged the government’s delay “constituted unjust enrichment” at the expense of the debtholders. The government received a stay to put together a settlement offer, accepted by more than 80 percent of the affected investors. The class action suit was eventually dismissed.
A decade later, a study by Terry Zivney and Richard Marcus investigated the implications of the incident by focusing on the day the first delayed payments were due. Their paper’s title makes clear their take on the event: “The Day the United States Defaulted on Treasury Bills.” They noted that Treasury yields rose steeply by 0.6 percent in one day and remained permanently higher, increasing annual borrowing costs by $12 billion. They concluded that “the default apparently warned investors that Treasury issues were not completely riskless.”
Why This Matters
Every time there’s a debt-ceiling crisis, market participants get nervous. Since mid-April 2023, one-month Treasury-bill yields have skyrocketed from around 3.3 percent to over 5.5 percent by mid-May. Securities typically thought of as risk-free have suddenly questioned. That costs the government more money to borrow. As Treasury yields act as a benchmark for bank lending, that in turn can make borrowing by corporations and individuals more expense. When an economy is facing a possible recession, that can tip the scales and turn that possibility into a reality. Markets don’t like uncertainty. Longer-term, there’s a reputational cost. Central banks worldwide might question the level of dollar reserves they hold. Once the U.S. is no longer seen as a safe haven, that could negatively impact the cost of borrowing for generations. Holders of Treasury securities around 1812, John Perry in 1934, and Claire Barton in 1979 would have taken issue with the notion that Treasury securities are risk-free.
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Stephen Foerster is a co-author, with Andrew Lo of MIT’s Sloan School of Management, of In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest