Fitch has come out with a research paper on repo, “Repos: Nongovernment Assets Still Prominent,” April 16, 2013. They bang the drum on structured finance assets being used as collateral in tri-party. It is a reminder that some habits die hard.
Fitch notes that:
“…Structured finance represents about 4%–5% of total U.S. triparty repo collateral, equating to roughly $75 billion funded through this short-term credit market. (Note: This figure understates the total, as FRBNY categorizes collateralized debt obligations (CDO) in the “other” category)…”
Although not the dominant from of collateral, it highlights that structured paper still plays a big part in tri-party.
“…Notably, the amount of non-agency structured finance funded through triparty repo is typically about 10 times greater than average daily trading volumes for this asset class…”
and
“…More than half of Fitch’s structured finance sample consists of subprime and Alt-A RMBS and CDOs…”
These statistics are of concern. Tracking volume is a hard thing to do and subject to all sorts of slippage – but if 10:1 under current market conditions is right, there is reason to wonder what happens to less stellar paper should markets come under stress. Haven’t we seen that movie?
“…Fitch’s analysis…indicates that the structured finance collateral within this sample consists of generally smaller sized, legacy-era securities, many of which are deeply discounted and of lower credit quality. These findings are consistent with Fitch’s prior studies of triparty repo collateral, suggesting that little has changed in the risk profile of this collateral despite the heightened supervisory attention…”
and
“…The median value of the roughly 4,300 structured finance securities in Fitch’s sample is $800,000, with roughly one-fifth of these securities less than $50,000….”
This raises all sorts of flags, especially when combined with the high-ish collateral/volume ratio. Small lots are harder to sell, at least without discounting the value. If the underlying collateral is less liquid in the first place and there is a lot to sell relative to average volume in the market, isn’t this a problem?
Why are these markets active? Pretty simple:
“…Structured finance repos provide a higher return opportunity for some money funds in the persistently low-yield environment, yielding an average of 63 bp per annum as of end-December, or almost four times more than the 17 bp yields on repos backed by Treasury securities. This yield differential likely stems in part from the relatively longer maturities of structured finance repos but also reflects the incremental risks associated with this lower quality form of collateral….”
We wish in the report there was more detailed data on haircuts for structured finance collateral. The paper says “The 8% median haircut as of end December implies roughly 14:1 leverage.” A break-out by type of paper would be helpful. Haircuts can cure a host of sins but they need to address specific collateral type and idiosyncratic liquidity issues.
So what can be done to control for this risk? Tri-party acceptable collateral criteria could include minimums on the size of a particular piece of collateral (“the shape” in tri-party-ese). Just as you might want to modulate risk by limiting how high a percentage of a single issue/issuer is taken in, perhaps taking only round lots will also protect against having paper that turns out to less liquid.
A link to Fitch’s website is here. You have to be registered to see the paper.