Stalemate Puts Strain on a Vital Debt Market

During the financial crisis of 2008, the vast and shadowy machinery of the financial system seized up, making a bad situation worse.

Five years later, as Washington struggles to reach a fiscal deal, these netherworlds are once again becoming a concern. Crucial elements of the system remain vulnerable to shocks.

The biggest is the market where Wall Street firms borrow billions of dollars of short-term debt each day just to run their businesses. This debt market is heavily dependent on money market funds, a major source of weakness in 2008. Before the fiscal battle flared up, regulators were calling for further measures to strengthen both the Wall Street debt market and the money market funds.

Adding to the worries on Tuesday, Fitch Ratings said that the United States’ AAA credit rating was at risk of a downgrade.

It said that even if the budget conflict is resolved, it could push up the cost of borrowing across the economy and harm long-term growth.

But with just two days to go before the Treasury Department says it will run out of room to borrow more, investors remained skittish.

The Standard & Poor’s 500-stock index fell 12 points, or 0.71 percent. Investors, fearing a government default, continued to shed Treasury bills that come due in the next few months.

Citigroup’s chief financial officer, John C. Gerspach, said on Tuesday that his bank held no Treasuries that come due in October.

The system is in many ways stronger today than it was in 2008. The government has been putting in place an ambitious overhaul to make banks and markets more resilient to shocks.

But the current flight from certain Treasuries adds a unique and unpleasant twist to the stress in the markets. Treasuries are widely held and have long been used to help put values on all sorts of other financial assets, from corporate loans to mortgages. They also underpin trades in the $600 trillion derivatives markets. As a result, doubts about what Treasuries are really worth could reverberate deeply through the system.

“That’s when the uncertainty and disruption starts to build,” said Donald L. Kohn, a former vice chairman of the Federal Reserve and now a senior fellow at the Brookings Institution.

Even if a fiscal deal is reached soon and a default is avoided, investors around the world may view American sovereign debt as tainted for some time. Some of the same difficulties that came with the European debt crisis may linger in America.

“It’s hard to think about a well-functioning financial system and economy when your risk-free asset is under threat,” said Jacques Cailloux, chief European economist at Nomura.

Still, ordinary banks appear better protected than they were in 2008.

They hold substantially more capital, the financial buffer they need to absorb losses. A deep recession caused by a government default would certainly damage the banks in many ways. But they appear adequately insulated from any losses on Treasuries. Banks in the United States held $166 billion of Treasuries at the end of June, according to figures from the Federal Deposit Insurance Corporation, a primary bank regulator. By comparison, they had $1.63 trillion of capital.

Activities outside traditional banking look more exposed, though.

Wall Street firms and their clients, for instance, borrow trillions of dollars through the so-called repo market. In this market, large investment banks borrow for very short periods from investors with spare cash, pledging assets like Treasuries as collateral for the loan. They use the market to finance the purchase of securities.

In 2008, the repo market froze. The Fed rushed in to support the market with enormous credit lines to banks. Since then, regulators have introduced measures to strengthen the repo market, but they say they want to do more.

Treasuries back one-third of all transactions done in the $2 trillion repo market that brokers use the most. A violent sell-off in Treasuries could reduce the value of the collateral that brokerage firms use in repo, making it difficult for them to do business.

If the repo system was impaired, it would be “very dangerous for the largest dealers because they might be unable to find financing for their securities,” said Darrell Duffie, a professor of finance at Stanford.

One often-identified flaw in the repo market is that it depends on cash provided by money market funds, the investment vehicles that individuals often think of as safe places to park their cash. The mutual fund industry has taken steps to gird the money funds. Even so, regulators continue to press for further measures.

The threat of small losses in the money market funds â€" perhaps from defaulted Treasuries â€" could prompt many investors to withdraw their money.

“Even if the funds do prepare themselves, they can’t control it if their customers are pulling money out of the funds,” said Scott Skyrm, a former Wall Street trader who writes a blog on the repo market.

Right now, the repo market indicators show that it is about as stressed as it was during the more perilous days of the 2011 fiscal battle, Mr. Skyrm said.

So far, the money flowing out of money market funds has not been overwhelming. Last week, large investors withdrew $20 billion from money funds that specialize in government debt, 2.5 percent of the total in the funds, according to figures from the Investment Company Institute.

But an actual government default could lead to much heavier withdrawals. The funds would have to sell more Treasuries, forcing their prices lower, and Wall Street firms would have to make do with fewer repo loans.

“With money market funds, we know there is always a risk of runs, depending on how investors react,” said Adi Sunderam, an assistant professor at Harvard Business School.

Though the Dodd-Frank law, passed in 2010, makes it harder for the Fed and the Treasury Department to bail out the repo market and money market funds, banking specialists say they believed the government would still step in.

Regulations that govern what the Fed can buy appear to allow it to purchase defaulted Treasuries, said Oliver I. Ireland, a partner at Morrison & Foerster, and a former lawyer at the Fed.

“I can’t imagine that the Fed wouldn’t find a way to keep the markets liquid in the event of a default,” he said. “The Fed has got some pretty robust contingency plans.”

Many people on Wall Street still expect the politicians to reach a deal in time. But the dangers of flirting with default could linger.

“The experience in Europe has shown that these contagion channels can be very violent and unexpected,” said Mr. Cailloux, the Nomura economist.