A frozen block of ice on a metal surface with 100 USD dollar banknote inside
By Tim Fernholz

There's been a brief resurgence of the idea that if the U.S. Congress doesn't agree to raise the debt ceiling by Oct. 17, a default wouldn't be such a big deal. "I'm not as concerned as the president about the debt ceiling because the Fed are the only people buying our bonds," Republican Sen. Richard Burr told reporters yesterday -- probably surprising the financial sector and foreign governments who actually buy most of those bonds.

But this is wrong on a number of fronts. And the scenario most people think of when they think of a debt going unpaid -- namely, creditors knocking on the door -- isn't the only one to worry about.

Rescheduling Isn't an Option

First, don't imagine that the government will be able to pay just the interest on its borrowing if there's not enough cash for everything. Even if the Treasury could reprogram its clunky payments system to pay bond coupons first, and even if that were legal, a series of large payments due on November 1 would leave the U.S. in arrears. Yipes.

Other than raising or eliminating the debt ceiling, then, the only solution would be some kind of radical action by president Barack Obama, like ignoring the debt ceiling altogether. That would incur a constitutional challenge. Even then, markets might might still question the legal backing of U.S. debt, and one possible outcome is massive spending cuts that plunge the United States into an immediate recession. Which would, incidentally, make it harder to pay down the debt, the very result that freezing the debt ceiling is supposed to prevent.

But many informed people are less worried about that than what might come first: A freeze in the tri-party repo market, akin to the cascade of troubles that followed the Lehman Brothers bankruptcy in 2008.

The Tri-Party What?

The tri-party repurchase market is where investment banks obtain $1.8 trillion in financing every day. In simple terms, it's like mortgages, only for buying bonds rather than buying houses. In slightly more complex terms, it's a revolving series of collateralized loans cleared through one of two middlemen, JP Morgan or Bank of New York Mellon. Money market funds, mutual funds and corporations hand over cash in exchange for rights to some kind of collateral proffered by banks and hedge funds who need to buy and sell securities. Typically, these trades are unwound daily.

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In 2008, more than a third of that collateral was mortgage-backed securities. When Lehman went bankrupt, its lenders began a "fire sale" of the securities it used as collateral, which drove down the value of other mortgage-backed securities, which led to more fire sales. This dynamic would eventually lead to a freeze in the repo markets, which, at the time, provided $2.6 trillion in funding to the banks each day. The sudden shrinkage in financing helped break the financial system until the Federal Reserve and, eventually, U.S. taxpayers, bailed it out.

Today, while the repo market is smaller, it's still important; the New York Fed held a seminar last week about the dangers of fire sales in the repo market. Today, most of the collateral in use is U.S. Treasuries and "agency securities" -- mortgage-backed securities guaranteed by the U.S. government:

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What Could Happen If the Debt Ceiling Is Reached

Right now, investors are snapping up long-term U.S. debt, seeing it as a safer bet than stocks during the government shutdown. Few, in other words, appear to be taking seriously the prospect that the U.S. might default on that debt. Still, you can see prices for very short-term Treasury bills falling as investors grow leery of owning bills that mature right around the time the U.S. can no longer borrow money to pay them.

But if the ugly day of a default comes, lenders may simply stop accepting U.S. debt as collateral. That will have the effect of sucking some $600 billion in liquidity out of the banking system. Unable to get funding for Treasurys, securities dealers would be pressured to sell them-or other assets-to find new funding, creating a fire sale dynamic. While banks have more capital now and are less reliant on levering up through the repo markets, an adverse situation could resemble 2008.

Even fears of this scenario could put pressure on the financial system. During the last debt ceiling face-off in 2011, overnight repo rates rose some 30 basis points as skepticism about the ceiling increased. So far, overnight repo rates haven't risen in reaction to the squabbling in Washington, but that's an indicator we'll be watching as the debt ceiling deadline draws nearer.

And, of course, this scenario is only about how the Treasurys work in the repo markets. U.S. debt is used as collateral for derivatives swaps and numerous other transactions; if they are suddenly worth less than expected, lenders can be expected to demand more collateral up front, putting even more pressure on the financial system. That's why pressure is building to raise the ceiling before the world's largest economy enters a scenario with so much uncertainty.

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If this is so serious you could’ve fooled me. The President is holding his ground. In their own words they are winning this argument in the court of public opinion. Obama has his eyes on 2014 and nothing else. He will allow the country to default so he can go full press and blame the other guys. The Debt will reach 17 trillion and the Democrats want another 1 trillion to last them till next year. Obama blamed GWB for raising the debt to 9 trillion for starting two wars but he brags how he ended one. What happened to the money saved from that? What happened to the money paid back from the bail outs?

October 09 2013 at 10:33 AM Report abuse +2 rate up rate down Reply

What "COULD" happen. People notice the word COULD, COULD, COULD but won't... The same BS hype of the Sky is falling, the fiscal cliff, the sequestration, the shutdown LMAO have all been bogus hyperbole to convince you, the dumb people who follow the sheep, to react with panic and chaos knee jerking just like you always have and do because you are far more stupid than you think but just as stupid as they know. It COULD, but it won't. The only thing that will happen by not increasing the debt limit would be that American politicians will have to live within the means of that which the American taxpayer can pay the taxes levied on them. In other words they will have to live like we have to live and only spend what we can afford otherwise we have to go without. Imagine that concept. LMAO. THE SKY IS GOING TO FALL AGAIN FOR THE HUNDRETH TIME but then it doesn't. lololololololol. Can you say...MO-RONS

October 09 2013 at 10:18 AM Report abuse +1 rate up rate down Reply
1 reply to findrobin's comment

You just don't get it, do you? When the panic sets in, it won't be the American voter; it will be the international financial world that panics. When it does, your precious 401k and retirement equities will lose half of their value over night. Didn't you read anything in the article? T-Bills and the U.S. dollar are the foundation upon which the entire global fiinancial system is built. Hurt that foundation and the system collapses. And then you are going to find out just how interconnected we really are and that undoing the catastrophe will be beyond anyone's ability to do; including our Fed.

October 09 2013 at 10:28 AM Report abuse rate up rate down Reply
1 reply to killkubota's comment

Then the interest rates will go up so Americans trying to live on their savings will have a chance. If you lose half of your savings "again" but the interest rates double, did you really lose anything? Or did just the big banks that own congress lose?

October 09 2013 at 2:29 PM Report abuse rate up rate down

Get real! The media is going to make this sound worse then it really is. You guys are good at blowing things out of proportion. Most Americans are against Obamacare, that's what this shut down is all about! Most of you media are liberalist and are help to push this Obama machine. We need this dictator stopped and Obamacare stopped! Enough money comes out of my check already for the 49% that are not working! I have no problem helping to pay for those that legitimately need it, but too many are taking advantage of the system. The debt ceiling isn't the problem, it's Obama and this administration!

October 09 2013 at 10:01 AM Report abuse +1 rate up rate down Reply

I see most of the posters here are clueless. This in not Obama's fault. Its the teaparty. If we had to face a shutdown every time a minority of a minority wanted something they cannot get through the democratic process, we won't have a government. You fools that blame Obama don't get that, do you? This is not a negotiation, its blackmail. And the teaparty is not democratic; they are anarchists. They want the international financial system destroyed. They want chaos and they don't care about the economy. Yep, its stupid, but thats what is happening. Get over the black man who is our overwhelimingly elected President and focus are the real threat; the tea party.

October 09 2013 at 9:58 AM Report abuse rate up rate down Reply
1 reply to killkubota's comment

Overwhelmingly elected? Who was that? Actually, this is the way the system was set up to work. It's working exactly as planned. A minority in the government is forcing the majority to negotiate with its constituents. The "minority" is doing exactly what its constituents sent them to Washington to do. The President doesn't like it because he thinks he should get everything his way without compromise. That's not the way the system works. We got rid of kings in the 1700's. ALL Presidents have to compromise. Otherwise, we don't need Congress at all.

October 09 2013 at 2:35 PM Report abuse rate up rate down Reply

Obsama is the problem that must be corrected

October 09 2013 at 9:42 AM Report abuse -1 rate up rate down Reply

The answer to all this crazy talk, is to fix our tax system. So many people pay little or no
taxes, using tax loopholes and tax write offs. So many people (lower income) use
government services, and do not contribute a dime to the system. The only way to
make a go at , stopping this train crash, is to go to a flat tax. Fix the corrupt
Medicare/Medicaid system So many people , abuse it, its not sustainable in its current
state. Make Social Security viable and strong for the future, by increasing the age
requirement , based on life expectancy. Rather then what we have now. This the
Conversation we should be having.

October 09 2013 at 9:18 AM Report abuse rate up rate down Reply
1 reply to bigwave48's comment

You can't base SS on life expectancy. A ditch digger can only dig so long. Few people can toss shingles on the roof of a house in their 80's. It sounds reasonable. It's just not possible.

October 09 2013 at 2:39 PM Report abuse rate up rate down Reply

Show a little leadership for once obama!!! Get both sides in a room, lock the doors, and don't come out until you agree on a deal. Enough of this obama the dictator crap. You have done nothing but spew lies about this situation, and I am sick of it!. You are and have been a complete embarrassment to this nation.

October 09 2013 at 9:15 AM Report abuse rate up rate down Reply

This is from the Constitution:
"The validity of the public dept of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned."
In other words, the debt MUST be paid. Not to pay would be unconstitutional. The Government brings in roughly $250 billion in taxes every month, and interest payment is $20 billion, so why are we even talking about default? Obama wants the debt ceiling raised because if he has to use the money to pay our bills, he can't pursue his agenda of expanding entitlements (and where did that word come from, anyway??) and the breadth and scope of the Federal Government.

October 09 2013 at 8:25 AM Report abuse +5 rate up rate down Reply
1 reply to anidaati's comment

The 14th amendment states that debts must be PAID. It doesn’t state that the country can continue to SPEND like drunk sailors and that cuts CAN’T be made. The House is exercising their constitutional right granted to them by the founders.

October 09 2013 at 10:40 AM Report abuse rate up rate down Reply

The White House (Obama) wants to avoid this fiasco solely because it will be his legacy. He doesn't care about "us."

October 09 2013 at 8:23 AM Report abuse +2 rate up rate down Reply
1 reply to sponsi's comment
No Name

I don't think either the Democrats OR the Republicans care about us. We are one year away from any meaningful election and they know that the voting public will have forgotten this by next year. They want their way, like any spoiled child, and d__ the consequences.

October 09 2013 at 8:36 AM Report abuse rate up rate down Reply

BO is such a POS

October 09 2013 at 8:18 AM Report abuse +1 rate up rate down Reply