Thinking the Unthinkable in the City of London

LONDON â€" Like many people, professional investors here do not really think the United States will default on its debt.

But even if it did, what could they do? Many see the outcome as a sort of financial nuclear winter, or at least a cliff, and have little inkling of what’s on the other side.

Luke Bartholomew, an investment analyst at Aberdeen Asset Management, summed up the sentiment.

“We haven’t done anything to hedge our global government bond fund portfolio for an explicit default because: a) we think the chances of default are still small; and b) the consequences would probably be so systemic and devastating it would be very difficult to hedge,” he said.

His views largely reflected those shared by a number of money managers interviewed over the past week in London, Europe’s financial nerve center. As the city contemplates the abyss that it hopes will never come, heads shake at what they see as the Americans’ inability to operate a government. The prevailing belief seems to be that crisis will be averted and that the politicians will come to their senses at the 11th hour. The alternative is simply too dire to contemplate.

“Like most people on this side of the pond, we watch with incredulity, really, at the positions they have painted themselves into and the unnecessary stress and damage,” said Tim Haywood, the head of the fixed income unit at the London office of GAM, an asset management firm based in Zurich. He said his firm had considered pursuing a complex hedging strategy, but came to view it as unworkable.

“Most of us put down the chance of an unresolved default of U.S. Treasuries at below 1 percent,” he said. “However, even with such a low percentage, the ramifications of unresolved default would be so serious that clearly we have to check everything to ensure that we survive and our customers’ capital is preserved.”

He said his firm was not heavily invested in the U.S. dollar and had a cash allocation that was more focused in Europe. But they were holding “a small number of Treasury calls,” or options contracts that give them the right to buy U.S. Treasury bonds, which, he conceded, “sounds completely counterintuitive.”

“It may be that the risk-free asset does re-emerge as being U.S. Treasuries after a calamity,” he said.

For Johannes Müller, the chief economist at Deutsche Asset & Wealth Management, a unit of Deutsche Bank, “The possibility of a default is seen as very, very low, so we thought about a risk case, and formulated a risk scenario, but the probability is a symbolic one.” He added, “I don’t think by and large the market is anticipating a technical default.”

What would happen if the United States defaulted on its debt?

“Oof,” said Oliver Gregson, an executive at the wealth management division of Barclays. “Honestly, wouldn’t want to go there. You would be talking about an event similar to ’08, you really would.”

Many, like Mr. Gregson, do not see the nominal debt ceiling deadline of Oct. 17 as the default doomsday.

“The U.S. is the world’s largest economy and they have a lot of things they could do to avoid that,” Mr. Gregson said. “You have talk about a superbond, or minting a trillion-dollar coin, or Social Security or Medicaid payments might be impacted. We can get past the 17th, there are all sorts of things they could do.

“I would say we’re tactically cautious and strategically optimistic,” Mr. Gregson said. “We are mindful of the tail risk from the debt ceiling debate and possible default. Clearly those tail risks are substantial, but the reality of that actually happening is limited. The vested interested of both sides, Republican and Democrat, is substantial enough that we think sense will prevail.”