4 debt ceiling scenarios freaking out traders

October 7, 2013: 5:00 AM ET

What could go wrong on trading desks if the U.S. defaults on its debt? A lot.

FORTUNE -- Government officials used to see it as part of their job to calm the markets. Not anymore. Last week, President Obama and Treasury Secretary Jack Lew both said they thought Wall Street wasn't freaking out enough about the possibility of a debt ceiling default.

Right now, most of Wall Street appears to be betting that a deal will get done. But on some trading desks, the possibility of a default is starting to sink in. No one knows what it means, but everyone agrees it would be bad.

Here are some of the ways traders think a default could result in a total collapse of our financial system, or at least a disastrous scenario.

The hot dog dilemma

Grilled Hot Dog on BunThe general consensus is that if the government defaults it will be on debt coming due in late October. But not necessarily. And that has some traders concerned. Why? Hot dogs.

Strategists at RBC Capital markets, in a report last week, said Wall Street's trading systems are not set up to sort out defaulted Treasury bonds from the rest. This is what Wall Streeters call the hot dog dilemma: Even if a small portion of the meat going into a frank is funky, you won't eat it.

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"When markets were set up, no one really ever contemplated the Treasury defaulting," says Michael Cloherty, who is the head of U.S. rates strategy at RBC.

We ran into this problem in the early days of the financial crisis. Even though relatively few home loans had defaulted, no one wanted mortgage bonds. The toxic debt had been ground up and mixed into various bonds. And those bonds had been ground up and stuffed into other bonds.

The problem could be worse in the Treasury market, which is generally made up of risk-averse investors. The fear of being stuck with a defaulted bond might cause many of those investors to run from the market altogether. U.S. debt prices would plunge. "It could be really, really bad," says Cloherty.

Debt ceiling's Y2K-like problem

y2k-620xaAccording to a number of traders, Wall Street's computer systems are programmed to automatically pass along U.S. government payments to bond holders. Even, perhaps, if those payments aren't made. Unlike other bonds, the computers aren't coded to check for the payments first, because everyone assumed Uncle Sam would always pay on time. Oops.

If the government stops making payments, big banks could be shelling out their own cash to pay interest on debt that's not theirs. That could cause some dealers to back away from the Treasury market, making it harder to trade U.S. debt. Or it could just be a drain on the banking system, making it difficult for banks to lend and trade.

MORE: Wall Street digs in for a debt default

Another problem: Traders leverage Treasury bonds to finance derivative bets and other transactions. Often the interest on Treasuries covers much of the carrying cost of those trades. And the transfers of payments are set up to be automatic as well. So a government default could lead lots of other traders to automatically default, triggering a wave of selling that could cause a variety of markets to tumble. It would be a mess.

Disappearing bonds (and credit)

Business man with no face, looking at cameraThe assumption is that defaulted Treasury bonds would continue to trade. But the bonds might not just drop in value. They could disappear altogether.

Rob Toomey, a staff attorney at Securities Industry and Financial Markets Association who watches government bonds, says that defaulted securities aren't allowed to trade without advance notice. The result would be that defaulted bonds would temporarily vanish. Traders won't be able to buy and sell them, and investors wouldn't be able to get their money back, for a time.

On October 24th alone, $120 billion could disappear from the Treasury market. That could cause a credit crunch. Overall bank lending only rose by $75 billion in the second quarter.

Repo madness

reefer-madness-620xaRemember the part in the movie version of Too Big to Fail when the guy playing Goldman Sachs's CEO Lloyd Blankfein (Evan Handler) is talking to Hank Paulson (William Hurt) and Paulson says "I'll call you back because GE CEO Jeff Immelt is calling." And Blankfein says "Why the heck is Immelt calling?"

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The reason was repos. Treasury securities underpin the so-called repo market, the main source of collateral for the overnight lending market that is often tapped by banks and corporations. Some are worried that the defaulted government bonds would no longer be considered good collateral, restricting short-term lending. At the very least we could see a spike in lending rates, making it less attractive to borrow. That's what happened briefly in August 2011.

Money market funds, which are one of the big holders of short-term Treasuries, could also have problems. If investors get nervous about short-term Treasuries they could pull out of money market funds as well. And the funds are the main contributors to the commercial paper market, another important source of funding for large corporations.

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