The debt stalemate in Washington is creating stress in a little-known but vital corner of the bond market, increasing the risk that banks, hedge funds and other investors will have to pay billions of dollars in additional costs if the U.S. defaults or is downgraded.

Rates are rising for repurchase agreements, or repos--a roughly $4 trillion market that greases the wheels of the U.S. financial system--as officials in Washington feud over how to bring down the nation's debt. And Wall Street is now calculating the damage that could ensue if the nation was forced to default on its debt early next month or, more likely, loses its triple-A credit rating.


If the U.S. is downgraded to double-A, analysts say, some money-market funds, companies and other lenders may start requiring $103 in Treasurys for every $100 in cash they provide in repo transactions. Even if the change in collateral requirements were small, the collective result would be akin to a widespread margin call across banks and other institutions and reduce the cash circulating in the markets and financial system.

For weeks since late spring, the U.S. repo market experienced unusual dislocations in which Treasurys were in such high demand that lenders were willing to make repo loans at interest rates close to zero.

But, in recent days, the debt-ceiling standoff and rising yields on Treasury bills have sparked concerns among some lenders. Traders say some corporations and institutions have pulled away from repos, preferring to hold cash amid the uncertainty, and repo transaction volumes have fallen as a result.

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