Shah Gilani: If there’s a “worst-case scenario” for this whole debt-ceiling debacle, this is it. After studying everything that could happen due to a downgrade of the United States’ top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset

sales that are so widespread that global stock-and-bond markets would plunge – and economies around the world would crash.

Tangible evidence that this frightening scenario could really play out surfaced on Monday, when the Chicago Mercantile Exchange (CME) announced it was increasing the “haircut” that it applies to U.S. government debt posted as collateral by traders transacting on the exchange.

The retail investors who didn’t just ignore this announcement altogether probably dismissed it as a boring bit of administrative housekeeping by the CME. In truth, however, this kind of re-evaluation of U.S. Treasury securities, widely used as loan collateral, could trigger global margin calls and widespread asset sales. If that occurs, it’s only a matter of time before the ripple effects of escalating margin calls could weigh down asset prices around the world.

Let’s take a look at how and why this could happen.

The “Haircut” Nobody Wants

Because U.S. Treasury bills, notes, and bonds are considered “risk-free” they are every lender’s preferred collateral class.

All of America’s too-big-to-fail banks, major securities broker-dealers and giant hedge funds – and most of the world’s biggest financial institutions – hold hundreds of billions of dollars of U.S. Treasuries that they use as collateral to borrow in the overnight and term “repo” market.

Traders use their U.S. Treasury securities to borrow more money to buy still more Treasuries, as well as other more-speculative securities. The intention is to leverage the capital they have by borrowing against balance-sheet assets to take on bigger positions.

But what happens if there’s no debt-ceiling deal by Tuesday – the theoretical day after which the country won’t be able to pay its bills?

The actual answer to that question may not matter as much as the uncertainty that’s been created. In fact, even with a deal – meaning there’s no default – it’s likely the United States is facing a reduction in its top-tier AAA credit rating.

In the event of a U.S. default, a downgrade, or a combination of the two, the Frankenstein-like facelift that will change markets for years to come is going to start with a “haircut” that trims the collateral value of U.S. Treasury debt.

Lately, the word “haircut” has been transformed to mean a loss – as in “my stocks went down in the bear market … man, I took a real haircut.”

But that’s not the technical definition.

A “haircut” is actually a securities-industry term that pertains to the U.S. Securities and Exchange Commission (SEC) Uniform Net Capital Rule 15c3-1. Securities broker-dealers, regulated by the SEC, have to maintain a minimum amount of “net capital” – or enough of a capital cushion to remain solvent.

When calculating their net capital, securities firms weigh their liabilities against their assets.

But not all assets are treated equally.

In some cases, such factors as credit risk, market risk and even its maturity can bring about an increase in uncertainty for certain assets. If that happens, the SEC can demand that firms “haircut” that asset – marking down its cash value using general formulas that discounts its “present value.”

The more an asset has to be haircut, the less its collateral value becomes.

The Collateral Calamity

Because U.S. Treasuries are U.S. government obligations and have traditionally been considered to be essentially risk-free, they typically haven’t had to suffer much in the way of haircuts.

In fact, short-term Treasury bills aren’t haircut and the longest-dated Treasury securities are only haircut by 6%. For the most part, haircuts on government securities are based on weekly yield volatility measures calculated by the Federal Reserve Bank of New York.

But since traders have used those Treasury securities to borrow more money to buy more government bonds and other (more-speculative) investments, a bigger-than-normal haircut on federal debt obligations will cause lenders to demand additional security on the loans they’ve made to leveraged trading desks around the world.

Leverage is all fine and good, as long as one of the following two things don’t happen to you.

The first thing that’s bad news for leveraged trader is if prices fall. If you’re leveraged enough, and the prices of the assets you’re loaded up with start to decline, you can quickly start eating into your capital base.

For example, if you are leveraged 10-to-1, meaning you have $1 of capital and a $10 asset position, the price of your position only has to fall by 10% to completely wipe out your capital. In the current market environment, a 10% move in just about any asset class can happen in a day or two – if not in a matter of hours or minutes.

The second thing that wreaks havoc with leveraged trades is if the collateral that’s been posted to borrow money (with which the leverage is accomplished) falls in value, then lenders will demand additional collateral, usually in the form of cash.

Of course, the double whammy occurs if the value of your collateral (in our present scenario, that means U.S. Treasury securities) falls at the same time that the securities you’re leveraged up with (we’re once again referring to U.S. Treasuries) also fall in value … well, you’re toast.

And the fallout won’t end with you.

The Ultimate Debt-Ceiling Debacle

This could actually result in a kind of “global margin call” – kicking off a worldwide de-leveraging scenario that could sink global markets and torpedo world economies. That’s the Frankenstein-like facelift I referred to earlier.

Here’s why.

The credit-ratings downgrade and an outright default play a big role in this, too. You see, while a ratings downgrade would affect America’s perceived credit quality, an actual default would change the market’s fundamental consideration of cashflow rights and the degree of certainty held about future payments regarding government obligations. Such a radical change in the quality and market-risk features of government securities would mean that they would be subject to deeper haircuts.

There’s the debt-ceiling-debacle “trigger” I’ve been talking about.

As leveraged institutions have to take deeper haircuts on the Treasuries they’ve put up as collateral for their loans, they’ll have to come up with additional collateral. If at the same time they are required to post additional collateral their leveraged positions are being marked down, there’s likely to be a sell-off of multiple asset classes as cash has to be raised.

Default is a game-changer.

Government securities will no longer be pure-interest-rate instruments. They will immediately assume the risk profile and characteristics of lesser-credit products and not be the baseline against which all other credits are measured, but demand new measures of their own default probabilities.

It’s bad enough that the U.S. government securities market is the largest securities market in the world. What’s even worse is that the derivatives market – which is at least 100 times as large as the U.S. government securities market – principally uses Treasury securities as collateral for their “private contracts.”

If you don’t think this is a real scenario, think again: Monday’s move by the CME shows that it’s already started.

It’s only a matter of time before the effects of building margin calls weigh on asset classes around the globe.

To be forewarned is to be forearmed: Let’s just hope that Washington resolves this whole debt-ceiling debacle before this global-margin-call cycle gets started.

Related ETFs: SPDR Gold ETF (NYSE:GLD), iShares Silver Trust (NYSE:SLV), SPDR S&P 500 ETF (NYSE:SPY), iShares Barclays 20+ Year Treasury ETF (NYSE:TLT), ProShares UltraShort 20+ Year Treasury ETF (NYSE:TBT).

Written By Shah Gilani From Money Morning

Shah Gilani is the editor of the highly successful trading research service, The Capital Wave Forecast, and a contributing editor to both Money Morning and The Money Map Report. He is considered one of the world’s foremost experts on the credit crisis. His published open letters to the White House, Congress and U.S. Treasury secretaries have outlined detailed alternative policy options that have been lauded by academics and legislators.

His experience and knowledge uniquely qualify him as an expert. Gilani ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When the OEX (options on the Standard & Poor’s 100) began trading on March 11, 1983, Gilani was working in the pit as a market maker, and along with other traders popularized what later became known as the VIX (volatility index). He left Chicago to run the futures and options division of the British banking giant Lloyds TSB. Gilani went on to originate and run a packaged fixed-income trading desk for Roosevelt & Cross Inc., an old line New York boutique bond firm, and established that company’s listed and OTC trading desks. Gilani started another hedge fund in 1999, which he ran until 2003, when he retired to develop land holdings with partners.