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Wall Street digs in for a debt default

October 4, 2013: 9:49 AM ET

Traders are talking about the prospects of "dirty prices" and other default oddities.

131003170635-concerned-trader-620xa-1FORTUNE -- On Thursday, the Treasury Department released a report anticipating what would happen if we have a debt ceiling default. One prediction: a financial crisis that could "echo the events of 2008 or even worse."

It's hard to see exactly how that could happen.

If Treasury bonds were to plummet after a debt default, that could cause other bonds to drop in value as well, creating big losses for the banks -- and perhaps putting them in jeopardy. But banks have been anticipating a jump in rates for a while. Many banks have already shown investors what would happen if rates suddenly rose three percentage points, which is a big jump. It's not pretty, but no bank appeared to be in jeopardy.

MORE: Why a default might not spike rates

What's more, Treasury bonds might not actually drop in value after a debt default, or at least not much. In fact, they could rise in price. If everyone assumes that Uncle Sam will eventually pay, traders say the market could switch to so-called dirty prices. Under that scenario, Treasury bonds would rise in value to compensate holders for the interest they are not getting paid, but everyone assumes eventually will.

The Treasury's report lacked any details on just how the U.S. government missing some bond payments would end up causing JPMorgan Chase (JPM) to fail. (This is just an example. Treasury didn't name names.)  A Treasury spokesperson declined to comment further on the report. A Federal Reserve spokesperson decline to comment on whether it was doing anything to make sure banks were ready for a debt-ceiling-induced financial crisis.

But clearly some on Wall Street are concerned. On Wednesday afternoon, a regularly scheduled conference call of Wall Street's major Treasury dealers turned into a impromptu default planning session. On the call, which had about 40 people including representatives from Citigroup (C), Goldman Sachs (GS), Morgan Stanley (MS), and other major foreign and U.S. banks, traders complained that they were getting little feedback from either Treasury or the Federal Reserve about how a default might work or if the agencies had drawn up any of their own contingency plans. "The conclusion was we needed to tell regulators as a group that a default would be really disruptive to the marketplace," says a person who was on the call.

MORE: Government shut down no problem for Twitter or other IPOs

DTCC, which is Wall Street's largest clearinghouse for stock and bond trades, said it was making sure it would be able to process trades if some Treasury bonds defaulted. "We continue to monitor the potential debt ceiling situation and, as part of our overall business contingency plans, are modeling a variety of scenarios," says a DTCC spokeswoman.

Big banks are reportedly filling ATM machines with more cash than usual just in case depositors get nervous about their accounts. That's something banks did back in 2011, the last time Washington nearly missed the deadline to raise the debt ceiling.

"I think it could be way, way worse than 2008," says Jens Nordvig, who is a fixed income strategist at Nomura.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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