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US debt default would have broad, long-term impact

By linking the debt ceiling to a credit event of catastrophic proportions, Treasury secretary Timothy Geithner was presumably trying to emulate former Treasury secretary Henry Paulson, who entered the history books in 2008 when he reportedly walked into a meeting with Congressional leaders armed with only a two-page draft Bill and demanded $800 billion to avert global financial meltdown.

With an 800-point fall in the Dow Jones Industrial Average the day before Paulson demanded decisive action, he closed the deal and Tarp entered the statute book. With treasury yields nailed to the floor by a combination of accommodative monetary policy and eurozone sovereign risk aversion, and equity markets so far ignoring the debt talks, Geithner and the Obama administration have no such sales pitch available.

But what if? Clearly, the potential risks to the global financial system arising from an unprecedented default by the ultimate too-big-too-fail institution could make the Lehman bankruptcy look like a dress rehearsal for financial Armageddon, according to worst-case scenario analysis from JPMorgan.

A late or missed interest payment on August 15 would almost certainly have broad systemic effects with long-term financial and economic consequences. Starting with a run on the government money market funds, contagion would soon sweep into the $3.9 trillion treasury repo market where the sharp repricing of collateral would likely increase haircuts, leading to widespread margin calls, forced deleveraging and the evaporation of risk appetite in lending markets. The growth in prime brokerage, mutual funds and ETFs since the last fiscal crisis in 1995 has driven a big increase in the use of treasuries as collateral in other markets, most notably OTC and exchange-traded derivatives.

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