The Wall Street Journal published an article on May 22nd, “The Fed Squeezes the Shadow-Banking System”, written by Andy Kessler. Much of it was about repo. While we appreciate the attempt to talk up repo by linking it to the real economy, we think some of the technical points were off in important ways. Here’s our commentary:
Kessler seems to blame Fed QE policy for high unemployment, using the repo markets as the connective tissue. If repo creates credit in the shadow banking market via re-hypothecation and haircuts, much the same way that the fractional reserve system does in the cash banking side, and collateral is being squeezed, then so is credit creation — so the argument goes. But we think Kessler might be over-reaching here.
“…The explanation lies in the distortion that Federal Reserve policy has inflicted on something most Americans have never heard of: ‘repos,’ or repurchase agreements, which are part of the equally mysterious but vital ‘shadow banking system…’” Repo, it can be argued, straddles the shadow banking world when credit is provided or received from entities outside of traditional banking regulation. A SPV financing RMBS, a money market fund or corporate investing their cash via repo, a hedge fund leveraging itself via repo trades – all could be characterized as shadow banking activities. But remember the bank executing a repo trade either with these clients or with other banks are subject to regulation and capital requirements, to say nothing of being collateralized. They are not in the shadows. Painting all shadow banking with the same “evil empire” brush is clumsy. There is a difference between maturity and liquidity transformation when it is on high quality safe assets versus on sub-prime mortgages or other potentially toxic paper; this is Risk Management 101.
Kessler writes “…Just as the monetary base is commercial banking’s gold, Treasury bonds are shadow banking’s gold. Credit created by repos funds financial instruments (such as credit-card debt and mortgages) but also inventories, drilling projects, even fiber-optic buildouts. Hedge funds use repos for over half their funding and live for these riskier projects…”
Wait a second – repo funding for drilling projects and fiber-optic buildouts? Did we miss that chapter? Maybe funding paper securitized by those projects, but if there is a repo desk out there taking in commercial collateral like that, risking illiquidity in spades to say nothing of nightmare stays in a bankruptcy; we’d like to talk to them. We really doubt it and hope it is not happening.
“…The $1.8 trillion of Treasury bonds sitting out of reach on the books of the Fed is starving the repo market of safe collateral…” Lets put this into perspective: the total outstanding Federal debt (as of Dec. 2012) was $16.457 trillion, with $11.661 trillion held by the public. So is this paper sitting at the Fed preventing the economy from reaching its full potential? If these securities were in the market, increasing supply, wouldn’t rates be higher, throttling the economy? Aren’t commercial loan rates more attractive than investing cash in repo or letting it sit at the Fed, earning IOER? Maybe the anemic economy is more about bank aversion brought on by headline risk compounded with weak demand for the kind of riskier leverage that some parts of the shadow banking complex now avoids? Aren’t more cautious banks and less crazy leverage good things?
Using the 10 year squeeze in March and tight repo levels now as evidence of repo markets causing a weak economy seem a stretch. The 10 year squeeze may have been less related to the overall repo market and more a function of market technicals. Some have blamed the 10 year squeeze on demand from increased collateral necessary for CCPs and other takers of collateral – we don’t agree for enough reasons that this should make up another article entirely. Since dealers can substitute collateral in CCPs, delivering the cheapest stuff they can find, it doesn’t make sense to blame a specific issue getting very special on CCPs. The current high demand for paper and accompanying low rates in repo could also be attributed to the reduction in UST issuance, cash finding its way into repo post-TAG expiration, money funds putting more cash into repo, or a continuation of the de-leveraging story.
And the swipe at repo traders: “Repos were often the backwater of Wall Street, where people the firm had to hire—sons or nieces of managing directors—were placed to do the least harm, until 2008 anyway.” Well, that is just offensive.
While we generally appreciate articles that support the validity of repo, we are concerned that this one misrepresented some of the subject matter. It might have been more accurate to talk about securitized debt including repo, or about how maturity and liquidity transformation outside of traditional savings and loan banks helps reduce unemployment, etc. To point all this to repo though doesn’t make the sense we hoped it might have.
A link to the article is here (although it may be behind the pay wall).