Debt ceiling debate is rolling back the clock to 2008 by Brendan Coffey @FortuneMagazine June 30, 2011, 3:01 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Come August 2, the U.S. government will be unable to pay its bond obligations. This simple fact has generated various reactions, from the view that defaulting is a necessary, if bitter, pill to get the country on the right fiscal path, to the quixotic claim that a default will actually help Treasuries because people always buy government notes when times are bad. Mostly, however, the reaction has been a shrug of the shoulders. A glance at the Treasury market shows little fear: yields on the two-year note fell to close at an all-time low last week, as investors bet a U.S. default is less likely than a European debt contagion being sparked by Greece. The Treasury market, at least, is probably right. Default by the federal government is akin to the Pope suggesting that maybe there wasn’t a Jesus Christ. Once that happens, it can’t be taken back, no matter how earnestly you proclaim otherwise afterwards. Treasury Secretary Tim Geithner understands this, and will do anything to avoid that fate. Default means foreign investors, who buy half our Treasuries these days, would direct at least some of their money elsewhere, driving up U.S. borrowing costs and thereby compounding the country’s fiscal problems. Already Geithner’s bookkeeping magic has bought extra time—the ceiling was originally going to be hit in May—and more juggling will extend the default danger out. And that’s a problem. How does the Treasury create more room to make its interest payments? By selling assets. The Treasury has $600 billion in mortgage-backed securities, agency paper, student loans and TARP-related investments. While insisting it has no connection to creating room beneath the debt ceiling, the Treasury already started a fire sale, announcing at the end of March it was going to begin selling off its $140 billion MBS portfolio. It is no coincidence that the sell-off underway in the MBS market started as the Treasury began selling. MBS values have dropped as much as 25% in just a few weeks, wiping out a year’s worth of gains, primarily for Wall Street investment banks. With four times that amount of other securities on the Treasury balance sheet—enough to fund normal debt-related activities for about half a year—further sales will likely make the investment banks suffer even further. And when investment banks start losing money, they pull up stakes and evacuate from the corporate lending market to cut their exposure. Loan brokers report it’s only been in 2011 that corporate borrowers with less than the best ratings and largest cash holdings have been able to borrow with relative pre-2008 ease again to finance basic activities, such as meeting payroll. If Treasury asset sales increase, bank lending to companies will decrease, followed by a shrinking of credit lines to consumers—two side effects that will stall an already sluggish economy. Think of it like the opposite of Quantitative Easing; it’s Quantitative Tightening. Even if there is no default, avoiding it without an agreement ahead of August could very well undo all the painful steps of the past two years. For one, think what happens to GM GM stock when the Treasury sells the $14 billion in shares it holds from TARP to meet an interest payment. It’s not pretty. So where is the safe haven if Washington’s game of chicken continues? Don’t look to Europe, where default remains a real concern in Italy. And it’s certainly not with higher-quality French and German bonds, where many institutional investors have moved into over the past year. Their banks have large exposure to bad European loans. Commodities will see some strength, but bars of gold and barrels of oil cost money to store and don’t generate income, something holders of bonds from pension funds to central banks rely on. There’s a chance that some top-rated corporate bonds, such as those issued by Johnson & Johnson JNJ and Microsoft MSFT , will improve, at least for a short time. But unless Congress enters its summer vacation with a deal to raise the debt ceiling and offer a roadmap to lower deficits in the long-run, the past of 2008 will prove to be a prologue to the rest of 2011.