Default would be catastrophic for big banks

October 11, 2013, 6:14 PM UTC

FORTUNE — JPMorgan and Wells Fargo kicked off bank earnings season Friday morning reporting some less-than-stellar results. Weak loan volumes, shrinking net interest margins, legal mishaps, lackluster trading activity, and a lousy mortgage market wreaked havoc on the megabanks during the third quarter. It even pushed JPMorgan into the red for the first time in years.

But the numerous problems the banks encountered in the previous quarter could seem like a walk in the park if the government fails to get its act together this quarter. Indeed, the latest efforts to end the budget standoff in Washington hardly seem adequate, making Thursday’s relief rally seem a bit premature. The deal currently being pitched by House Republicans would continue to leave the nation’s banking sector vulnerable to any number of fatal ailments, many of which could even trigger a 2008-like financial meltdown.

The government shutdown seems to be getting very serious, very fast. What began as a Republican power play has suddenly turned ugly. Now thousands of government workers and private subcontractors won’t be getting paid on time, the negative consequences of which will undoubtedly ripple throughout the economy.

Banks have tried to be generous with those impacted by the shutdown, with some even allowing their customers to freely overdraw their accounts to cover the bills. While that is good for the consumer, it amounts to lost profits for the banks. It is unclear how much longer the banks can afford to be generous.

MORE: Government shutdown’s biggest villain? Pride.

A prolonged government shutdown is hardly in the best interest of the banks as it would weigh heavily on loan volumes, forcing profit margins at the banks to shrink to critical levels. Credit quality will suffer as a result, which would force the banks to either lower their lending standards or deny potentially good customers some solid loans, neither of which seem very appealing.

But that’s not all. The banks are having a hard time writing mortgages due to the partial closure of the Federal Housing Administration. If they can’t sell off those mortgages to the government, then they will miss out on a big chunk of cash. This should have a strong impact on both JPMorgan (JPM) and Wells Fargo (WFC) in their next quarterly earnings as the two underwrite nearly a quarter of the nation’s mortgage market.

The government shutdown clearly isn’t a great deal for the banks. If it continues, it is probably safe to say that many banks would be reporting losses this quarter. Yet the shutdown, as harmful as it has been and will continue to be on the banks, is nothing to compared to the magnitude of destruction that would be unleashed if the U.S. breaches the debt ceiling.

MORE: J.P. Morgan’s current woes may be the least of its problems

At issue would be bank capital, which, for better or worse, is largely made up of Treasury bonds. If the government does not raise the debt limit and defaults on its debt in any way, the value of Treasury bonds all across the curve will fall as yields spike. It is unclear how far they would fall, but nearer-term bills will probably experience the worst blow.

The results could be catastrophic. If the value of a bank’s capital cushion falls suddenly, then it would immediately cut back on lending. Eventually the bank would need to fill the hole created by the devalued Treasuries in order to maintain minimum capital requirements. That means it will have less money to lend to the public markets, a negative for the economy.

But probably the most troubling impact of a government default is its impact on a bank’s broker-dealer operations. Treasuries are used as collateral in trading and are viewed as being as good as cash. If they are devalued in a default then the entire collateral system would break down. Banks and other financial institutions would be hesitant to lend to one another as they hoard capital, causing the repurchase (or repo) market to collapse. Without adequate cash to facilitate trades, a broker-dealer is doomed. This is how Bear Stearns and Lehman Brothers collapsed in 2008, and it will most likely be the cause of the next major bank collapse.

MORE: Why China won’t sway the debt ceiling debate

The Republicans floated a compromise Thursday that would raise the debt ceiling just enough to cover an additional six weeks of spending but would keep the government closed pending negotiations with the Obama administration. At this point it is unclear what the Republicans really want besides the lifting of a medical device tax which goes to fund the Affordable Care Act (Obamacare). In any case, the markets rallied on the news, giving back around half of what they have lost so far since this government sleigh ride began.

Given all the negative consequences a default could have, banks would be wise to boost their capital and hunker down just in case Washington fails to get its act together by the new deadline.