By Karen Brettell and Richard Leong
NEW YORK, Oct 9 (Reuters) - Banks and money market funds are beginning to shun some Treasuries normally used as collateral in the $5 trillion repurchase agreement market, a sign that the deadlock over raising the U.S. debt ceiling could disrupt a key source of day-to-day funding for the financial system.
Treasuries are often pledged against short-term loans in repo, funds used broadly across the financial system to pay for investment, trading and other operations vital to the day-to-day activities of many companies.
On the ninth day of partial government shutdown, investors are getting more nervous that Congress may fail to raise the debt ceiling, leaving the United States at risk of defaulting on debt that comes due or has coupon payments in late October and early November.
Many financial businesses depend on repo funding, and any disruption could spread to other markets. So far, liquidity issues appear contained. But even a brief default could cause large disruptions to payments, settlement and transfers of affected Treasuries.
To prepare for that possibility, which is still small, banks and money funds have begun taking steps to avoid any exposure to Treasuries they see at risk of delayed payments. Interest rates on bills maturing at the end of October have risen sharply in the last week.
"Investors are worried about holding Treasury bills and coupon securities in late October through the middle of November, which may face delayed payments. Those fears are overblown, but clearly some people are concerned," said Boris Rjavinski, rates and rate derivatives strategist at UBS in Stamford, Connecticut.
The overnight rate to obtain cash in repo was last quoted at 0.14 percent after rising as high as 0.17 percent, a level not seen since early May and sharply higher than the rate of 0.09 percent on Tuesday and 0.07 percent a week earlier.
Some banks have begun to stipulate that they will not accept certain Treasuries to back trades. This includes trades they make with clients and in the interdealer market, where trades are routed through a central counterparty, the Fixed Income Clearing Corp (FICC), said traders.
"In the interdealer market, cleared, term-repo trades are starting to have stipulations that there are no intervening coupons, which means that some dealers do not want to accept collateralized loans that would potentially be affected by a missed coupon payment," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.
At the same time money market funds are shifting their activity away from the tri-party repo market, and instead are lending directly to banks, where they can more easily specify collateral that they don't want to accept for loans.
"There are several money funds that have resorted to bilateral transactions rather than tri-party in order to ensure they get the collateral they want. Altering agreements at the tri-party is a lot more challenging," said Guy LeBas, chief fixed income strategist at Janney Capital Markets in Philadelphia, Pennsylvania.
In tri-party trades, JPMorgan Chase & Co or Bank of New York Mellon Corp act as intermediaries for lenders and borrowers and arrange for the settlement of the loans and the collateral behind them.
Traders also said money funds are avoiding buying the affected Treasuries as part of their regular Treasuries purchases, while selling of the bills has accelerated this week.
Fidelity Investments and PIMCO have both said that they are avoiding Treasuries bills that mature in the danger zone.
Treasury bill rates continued their dramatic increase on Wednesday. The interest rate on the T-bill issue due Oct 17 rose 17.5 basis points to near 0.46 percent, which was a level not seen since the height of 2008 global financial crisis. Several other maturities were also trading at elevated yields.
U.S. Treasury Secretary Jack Lew has warned Congress the United States would exhaust its borrowing capacity no later than Oct. 17, at which point it would have only about $30 billion in cash on hand.
Banks have been increasing their borrowing from the Federal Home Loan Banks (FHLB) in recent days, a sign that they are already aiming to shore up liquidity to offset any disruptions in the repo market as money funds are increasingly reticent to lend through the tri-party system.
"It appears that the FHLB is lending to financial institutions has been implicitly funding some of the pullback in the triparty repo system," LeBas said.
The ultimate liquidity backstop, were it needed, would likely be the Federal Reserve.
"The Fed has not pulled out its bazooka yet, that would be some form of lending from the discount window or a direct lending program that would take all sorts of collateral. They can stop liquidity (problems) from spiraling out of control, I don't think they are near to using it," LeBas said.