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Repo markets prepare for operational risks amid U.S. default fears

By Karen Brettell

NEW YORK (Reuters) - Banks and investors are fine-tuning plans to try to reduce the risk that operational failures will disturb crucial short-term lending markets if the U.S. Treasury is late in making its debt payments, though many are skeptical that any U.S. default could be managed smoothly.

Anxiety over the lack of agreement in Washington to raise the U.S. debt ceiling has risen. U.S. Senate negotiations were suspended on Tuesday until House Speaker John Boehner can work out a plan that can pass the House of Representatives.

The U.S. is still seen as very unlikely to default on its debt, but the impasse has left nerves increasingly frayed. Short-term Treasuries bill yields have surged as banks and investors shun the debt, while the cost of borrowing in the $5 trillion repurchase agreement market has also jumped.

"You've already seen significant disruptions, even though we're a long way away from any of the really risky dates. People are preparing earlier this time around," said Michael Cloherty, an interest rate strategist at RBC Capital Markets in New York.

A key concern by market participants is that a delay in making Treasuries payments could disrupt operational systems at the center of short-term lending markets. This could add to confusion and a likely pullback in lending as investors worry over how many other issues are at risk of missed payments.

"Operationally, it's going to be a mess to clear it up," said Bret Barker, portfolio manager at TCW in Los Angeles.

The New York Fed's Fedwire Securities Service, which is used to hold, transfer and settle Treasuries pledged to back repo loans, would need some manual daily adjustments to ensure that defaulted debt can continue to be transferred.

Traders said that they will be able to extend the maturities of affected Treasuries if they receive enough notice from the Treasury, which will allow the debt to continue to circulate. The maturities of affected securities may be able to be extended as late as midnight, or slightly after, on the day before the payments are due, these people said.

The Treasury, however, is seen as unlikely to make such an announcement until the last possible minute, as it would want to delay any potential default on hopes that Congress would reach a deal on the ceiling. That would complicate any contingency planning, traders said.

Spokespeople for the Treasury and the New York Fed declined comment.

U.S. Treasury Secretary Jack Lew has warned Congress the United States would exhaust its borrowing capacity no later than Thursday, though many market participants see the government as likely to be able to fund itself until late October, with a key date being October 31 when around $150 billion in debt payments are due.

Others warned that planning for a default is uneven across firms, and that preparations including maturity extensions on the Fedwire may still not resolve all operational risks.

"These contingency actions, if implemented, would only mitigate, not eliminate, expected operational difficulties in the event of delayed payments on Treasury debt," the Treasury Market Practices Group (TMPG) said in meeting minutes from last month.

The group, which includes representatives from Goldman Sachs, Morgan Stanley , JPMorgan Chase , Citadel Investments, BlackRock, Fidelity Investments and others, added that there were concerns "that contingency planning was uneven across market participants."

Lew also warned on Thursday that the nation's payment systems are not set up to allow officials to pick and choose broadly between its payment obligations if Congress does not increase the government's borrowing authority and allows it to default.

"Anyone who thinks it can be done just doesn't know the architecture of our multiple payment systems. They are very complex. They were designed properly to pay our bills. They were not designed to not pay our bills," he said.

(Additional reporting by Richard Leong; Editing by Marguerita Choy)

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