On Thursday, FedFin analyzed a key Senate Banking hearing in a client report we called DEFAULT. We very much hope it’s the first and last in this series, but events on Friday are not encouraging. I’m confident the Federal Reserve will pull a very big bunny from its magic hat on October 17 if default looms, likely deploying the reverse-repo facility established to ease “tapering” to throw as much liquidity into the global markets as the financial system needs to keep its lights on. But, liquidity worries can of course quickly lead to solvency fears – we learned this the hard way in 2008. U.S. and global regulators will, I trust, stay their hand and not sanction struggling firms unless or until market problems are so severe that nothing but a full-bore deployment of Dodd Frank’s resolution powers can save it. Comforting thought, that.

It’s hard to find much to say about the shutdown and debt debacles that isn’t deeply dour. Those of us who live in the District of Columbia worry that garbage will rot on the streets and ambulances will sit idly by as our city shuts down next week due to Congress’ intransigence. Still, most of us are better off than kids awaiting urgent clinical trials or elderly veterans deprived of medical care. This, though, is just the warm-up. Secretary Lew has confined himself to inspecific, if dark, predictions about the catastrophe that will befall financial markets should Congress let debt go past the current ceiling. For a more detailed – and way brightening look at the mechanics of a default in the financial markets, I commend the testimony of the Securities and Financial Market Association’s Ken Bentson at the aforesaid hearing (http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1602745e-d1ac-4f55-9ec1-fe8a4cc2370b). An excerpt of note:

“[O]ver the course of the industry’s consideration of the dangers of default, no scenario presents a clear cut answer. Indeed, the settlement arrangements for Treasury securities do not contemplate or recognize the possibility of a default and thus the ability to sell, finance, or post as collateral, defaulted Treasuries may be compromised. This ultimately could lead to a liquidity drain from the market. It is important to note that Treasury securities are a key factor in the daily financing of market operations with the U.S. Treasury repo market totaling between $1.2 and $1.9 trillion daily. Undermining that market would have a deleterious effect on every market participant.”

Mr. Bentson’s numbers for Treasuries in repos are right, but they belie the gravity of market chaos that could ensue. Total daily volume in the repo market is, according to SIFMA, $5 trillion a day. Suffice it to say that, under none of SIFMA’s scenarios does the market shrug off a default, with the testimony making clear that even “prioritization” – a preferred solution by some on the Hill – sends the market into the abyss.

This, of course, the Fed knows well. It has kept its cool – neither wringing its hands in public or announcing emergency measures – because, as one Fed official privately said yesterday, to show that the Fed might be able to manage markets during a default could well be to encourage Congress to let it happen. But, behind its granite facade, the Federal Reserve is very, very hard at work. The Treasury Market Practices Group, an industry/Fed effort to keep things cool, has been working since the 2011 debate brinkmanship on ways the FRB could process Treasury securities without having to touch those in default. Still, two years later, it’s at best unclear if Fedwire could in fact engage in any such legerdemain. Thus, the FRB might well be forced to weigh in still more forcefully – enter the reverse-repo facility and whatever else the Fed can muster despite the Dodd-Frank ban on emergency interventions of the sort that followed the 2008 near-death experience.

I trust the FRB will avert chaos, although I know folks at the Fed aren’t so sure they’re up to so herculean a task. When we get through this, the central bank will be still more convinced that repos pose tremendous and systemic liquidity risk. Options to address this were discussed at a Federal Reserve Bank of New York conference on October 4, where the FRB kept its official jaws firmly zipped on the default crisis. But, FRB-NY President Dudley did make it clear that one option—declaring the repo activities of the two clearing banks to be “financial market utilities” – was very much under consideration. JPM and BNY – get ready for a phone call.