Bloomberg News

El-Erian Says Massive Consequences of Default: Tom Keene

July 27, 2011

(Adds El-Erian comment in sixth paragraph.)

July 27 (Bloomberg) -- The U.S. faces “massive consequences” if a failure by lawmakers to lift a ceiling on the nation’s debt leads to a default and loss of its top rating, Pacific Investment Management Co.’s Mohamed El-Erian said.

While a credit-rating downgrade likely wouldn’t cause credit markets to freeze as they did after Lehman Brothers Holdings Inc.’s collapse in 2008, the world’s largest economy would experience “headwinds” to growth and employment, already in a crisis, El-Erian, chief executive and co-chief investment officer at the world’s biggest manager of bond funds, said in a radio interview on “Bloomberg Surveillance” with Tom Keene.

“If the U.S. defaults, there would be massive consequences,” El-Erian said today from Pimco’s headquarters in Newport Beach, California. “People are concerned, but they sort of think it’s a very, very low probability, and we would agree.”

Treasury Secretary Timothy F. Geithner has said the U.S. will run out of options to prevent a default unless the $14.3 trillion borrowing limit is increased by Aug. 2.

Standard & Poor’s, which has given the U.S. a top AAA ranking since 1941, said on July 14 that the chance of a downgrade is 50 percent in the next three months and may cut the rating as soon as August if there isn’t a “credible” plan to reduce the nation’s deficit. S&P has “set out a very clear timetable” that may lead to a U.S. downgrade and “will be accountable whether it sticks to that or not,” El-Erian said.

‘Explicit Timing’

“S&P is out there with very explicit timing, very explicit conditions,” he said. “It’s a moment of truth for the rating agencies just as it’s a moment of truth for Washington.”

BlackRock Inc., Franklin Templeton Investments, Loomis Sayles & Co. and Western Asset Management have also said that the U.S. faces losing its top-level debt rating as officials struggle to raise the borrowing limit and reduce spending.

House Speaker John Boehner postponed today’s scheduled House vote on his two-step plan to raise the debt limit, which the White House said Obama would veto, after the Congressional Budget Office said it would save just $850 billion rather than the advertised $3 trillion. Senate Majority Leader Harry Reid’s plan would save $2.2 trillion over 10 years, short of its $2.7 trillion goal, the CBO said today.

Pimco Expectations

While Pimco’s “baseline” expectation is that the U.S. will avoid a default, markets for commercial paper and repos, used by securities dealers to finance holdings and increase leverage, are showing signs of concern that the U.S. may miss a debt payment, El-Erian said.

“The very first thing I do now is I go over to our money market desk and ask them what you are seeing today,” El-Erian said. “How’s the repo market operating? Just the functioning of the market because that is what can really trip an economy. So far it’s functioning OK, but we’re seeing some pressure.”

Following a U.S. downgrade, the dollar may weaken over time and equity markets would likely decline, El-Erian said. Yields on longer-maturity Treasuries may rise relative to those with earlier maturities on a rating cut amid concern of worsening credit quality, he said.

“It’s undeniable that this whole debacle is leading to lower growth, higher unemployment and more erosion of the U.S. in the standing of the global economy,” El-Erian said.

Dollar’s Decline

The Dollar Index is little changed in July and the U.S. currency weakened against 11 of its 16 most-traded peers, according to data compiled by Bloomberg. Treasuries due in 30 years yield 3.84 percentage points more than those maturing in two years, compared with a spread of 3.68 percentage points on May 5, the tightest this year.

The U.S. unemployment rate rose for a third straight month in June to 9.2 percent, pointing to an economy lacking momentum entering the second half of the year. Employers added 18,000 workers to payrolls, the fewest in nine months and less than the most pessimistic forecast in a Bloomberg News survey of economists.

Bill Gross, the founder and co-chief investment officer of Pimco, increased holdings of Treasuries and bonds outside the U.S. last month while cutting money-market securities.

The $243 billion Total Return Fund managed by Gross boosted its investment in U.S. government securities to 8 percent of assets in June from 5 percent in May. Bonds in developed markets outside the U.S. rose to 13 percent of holdings from 10 percent. Cash and equivalents dropped to 29 percent from 35 percent.

Pimco, which has been criticized for missing this year’s rally in Treasuries, revised how it listed asset holdings last month to show that its flagship fund held U.S. government debt. Gross said he bought 2- to 3-year notes since U.S. bills are returning close to zero and the purchases shouldn’t be viewed as endorsement of the Treasury market because yields on longer- maturity debt are still too low given his outlook for inflation.

--With assistance from Julie Hirschfeld Davis and James Rowley in Washington. Editors: Dave Liedtka, Dennis Fitzgerald

To contact the reporter on this story: John Detrixhe in New York at

To contact the editor responsible for this story: Dave Liedtka at

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