What happens in a US debt default? 10 October 2013 Last updated at 16:19 By Kim Gittleson BBC business reporter, New York If US politicians cannot agree to raise the borrowing limit, the US could default on its debt by the end of October. The US Treasury has issued a dire warning of the possible consequences. "There might be a financial crisis and recession that could echo the events of 2008 or worse," it said in a recent report. But how can the world's largest economy stop paying its bills? Here's what happens when the tap is turned off. At its most basic level, a default is when a person or an entity cannot repay a debt on time. For instance, when a person can't make a payment on a mortgage or a car loan. When a country does this, it's known as a sovereign default. This is when the country cannot repay its debt, which typically takes the form of bonds. So if the US were to default, it would essentially stop paying the money it owed US Treasury bond holders. A quick refresher: the US government spends more money than it collects in taxes. So to make up the shortfall it raises funds by asking investors to buy US Treasury bonds. Investors, such as the Chinese government and pension funds, do this because these bonds are seen as a safe place to invest money. No one really knows exactly what would happen, but the likelihood is that markets around the world would plunge and global interest rates would rise. This is because if the US government could not repay the money it owed bondholders, the value of the bonds would decrease. And the yield - the return the government pays to an investor - would rise. This is because it would be perceived as a less safe investment. This would prompt interest rates around the world, which are often tied to those of US Treasuries, to spike. AAA-rating The best credit rating that can be given to a borrower's debts, indicating that the risk of borrowing defaulting is minuscule. US Treasury Secretary Jack Lew has warned that if a deal to increase the nation's borrowing isn't reached, the Treasury will exhaust the current extraordinary measures being used to pay the nation's bills by 17 October. These bills include not just the interest on bonds but things like Social Security and veteran benefits. Mr Lew has insisted no one really knows what will happen if and when the money runs out. The US Treasury will still be taking in revenue in the form of tax receipts, so it could pay some bills, but possibly not all of them. The most obvious option - to prioritise payments to bondholders so that the US would not be in default - has been ruled out by the Obama administration, and might technically be illegal, according to a study by Columbia Law professors. Ideally, though, the Treasury would use the money from tax receipts - which would still be flowing into its coffers after the debt ceiling is breached - to pay only the interest it owes on bonds that have already been issued. Strangely, no one really knows exactly how it works. Each day, the US Treasury receives a little over two million bills from various federal agencies. According to analysts at Credit Suisse, there are three main offices that pay those bills: the Department of Defense Disbursing Offices, the Bureau of the Fiscal Service and the Financial Management Service. Technically, the payment systems can be turned on - to make payments - or off - but not much else. If prioritisation were possible, the US Treasury would probably turn off the tap at the Department of Defense Disbursing Offices and the Financial Management Service. That would leave the Bureau of Fiscal Service, known colloquially as the Fedwire, which pays money to bondholders. There are quite a few coming up in the next month; the biggest ones are due on 1 November. After 17 October, the US government will only have around 68% of the funds it needs to pay its bills for the next month, according to a report by the Bipartisan Policy Center. This means that technically, the government could continue to pay some bills. However, daily revenue intake can fluctuate wildly, making it difficult to plan. US Treasury: Upcoming payments Source: Bipartisan Policy Center 23 October Social Security benefit payment $12bn 28 October Federal employee salaries $3bn 30 October Medicaid payments to providers $2bn 31 October Interest payment on public debt $6bn Medicare payment to providers & plans Military active pay, retirement, and veteran benefits payments $18bn $25bn $12bn 14 November Social Security payment 15 November Interest payment on the debt $29bn Not really. There are three examples in US history that come close to default, with the most recent occurring in 1979. Then, the US Treasury inadvertently defaulted on $122m due to what it said was a word processing error. Though the error was quickly fixed, and even though $122m was a tiny fraction of the $800bn in debt that the Treasury had at the time, a study found that the mini-default raised the cost of borrowing by 0.6%, or $6bn a year. The other two instances, in 1933 and in 1790, both involve defaults akin to the current situation in Greece, when creditors were forced to take less money than what they were owed. Some economists have defined this as a default, but it's murky territory.