Israel Unprepared as U.S. Debt Default Draws Near

Officials admit to having no contingency plans for implosion of U.S. bond market; Israeli banks' core capital could absorb shocks, but would suffer losses.

Is Israel prepared for the possibility that the U.S. government will reach its legally mandated debt ceiling on Thursday?

If the worst-case scenario comes to pass, and the deadlock between the White House and Congress is not resolved in time, the U.S. bond market could collapse. A shock like that would reverberate across the global economy, including Israel's.

In fact, such an apocalyptic scenario is being shrugged off by policy makers in Jerusalem. When asked by TheMarker what steps they were taking, one official said that was akin to asking about the contingency plans in the event Tel Aviv is hit by an atomic bomb. Another laughed off the question by suggesting the only policy option left would to invest in an online currency like Bitcoin.

As the responses to TheMarker's queries shows, Israel has done little or nothing to prepare for a crisis of this magnitude or to assess the extent of its exposure. But former Finance Minister Yuval Steinitz, now minister for strategic and intelligence affairs, has been urging the government to make some kind of preparation, at the very least by devising models to assess the worst risks.

Israel's vulnerabilities include the Bank of Israel's foreign currency reserves, which are mainly invested in U.S. treasury bonds; the banking sector's capital, which is likewise held in U.S. treasuries; and the public's savings invested in the local capital market, which is at risk of collapse of its own in the event of a U.S. crisis. Another possible risk lies with Israeli government debt, some of which is backed by U.S. guarantees.

Trying to elicit answers from the policy makers responsible for preparing for that day and answering the questions Steinitz has asked elicited no clear answers.

Officials at both the Finance Ministry and the Bank of Israel assert that the odds of a bond-market collapse are very low. They noted that the last time a crisis of this magnitude seemed imminent – just over two years ago, when Moody’s Investors Service lowered its rating on U.S. debt – the exact opposite occurred: U.S. government bond prices rose. The reason, ironically, is that U.S. treasuries are regarded by the markets as the world's safest investment. In times of crisis, investors buy them as a safe-harbor asset even when the crisis itself revolves around the soundness of U.S. debt.

This time as well, Israeli officials are confident that the worst-case scenario won't occur. In any event, they say, if it the worst does happen and U.S. treasury bond prices collapse, there isn't much Israel can do to protect itself. Because they are regarded as so safe, all the world's fixed-income markets revolves around their price movements in good times and in bad. Most of the Bank of Israel's reserves and the capital of the country's banks are invested in U.S. treasuries and nothing can be done to change that. Nor would trying to spread the risk in expectation of the worst make much difference, given the global dominance of the U.S treasury.

Steinitz nevertheless insists there are steps the government could take, such as temporarily increasing guarantees to banks and critical industries to tide them over any temporary collapse of their American bond holdings. That assumes that any crisis would be brief, measured in weeks or months only.

But on Sunday no one at the Finance Ministry was prepared to say any such plans were under consideration.

In any case, the approximately $80 billion in forex reserves held by the Bank of Israel are relatively hedged. While the reserves are largely held in U.S. treasuries, this is mostly short-term debt that is least vulnerable to big price swings even in times of crisis.

That weighting toward short-term debt reflect the central bank's assumption that U.S. interest rates will rise over the next few years as the U.S. Federal Reserve winds down its quantitative easing program. When that happens, U.S. bond prices will decline.

As to the capital of Israeli banks, the Bank of Israel believes their exposure to U.S. government debt in not particularly large. It apparently amounts to 10% of the banks’ combined capital, on average, which means that even if U.S. treasuries fall sharply the banks will not be very badly hurt.

Nevertheless, that 10% is an average for all of Israel’s banks. But Israel Discount Bank, for instance, has quite considerable holdings of U.S. debt issued by U.S. government mortgage lenders. Moreover, stress tests conducted by the Bank of Israel to assess the potential scope of losses in the event of a financial crisis similar to or more severe than that of 2008 showed that Israeli banks’ core capital was big enough to absorb major shocks. They would, however, suffer major losses.

But at this stage, the central bank isn’t taking any steps to address the risk.

Reuters