Bloomberg article “Bonds Stop Flowing as Collateral Gets Stuck at ECB” doesn't get it all right

The December 21, 2011 story in Bloomberg by John Glover “Bonds Stop Flowing as Collateral Gets Stuck at ECB” makes some important points about the state of repo in Europe but the article really confused issues too. A couple of the points made were (and our take on them):
  • They call re-hypothecation “financial alchemy” Really? It’s not that complicated. We suggest the author takes some time to draw the boxes and arrows for repo flows. Why do journalists think that just because collateral turns over, it is necessarily a bad thing?
  • The reporter is accurate saying that when collateral is repo’ed with the ECB, it can’t be recommitted. That is also the case with tri-party repo, collateral used at a CCP, and any other time when an end investor needs collateral. This is not news.
  •  “The disappearance of the unsecured credit markets as the sovereign debt crisis deepens has underlined the importance of secured borrowing through repurchase agreements.” Absolutely true.
  • Barbara Ridpath, the CEO of the International Centre for Financial Regulation was quoted as saying “Bankers realized that if they took collateral, two good things happened….One, they could stop looking at the credit of a counterparty. And two, they could get ahead of other creditors in a bankruptcy because they had security.” While the latter point is correct, we believe the former is far from the truth. Repo isn’t a non-recourse obligation. It is a contingent claim – you only get to liquidate the collateral side if and when the counterparty defaults and the probability of the counterparty defaulting is always important. Every trader and credit officer knows this simple truth: ignore the counterparty at your own risk.
  • Simon Gleeson, a lawyer at Clifford Chance, was quoted as saying “Once you engage in a repo with me, you no longer have the assets, you have a credit claim against me….A wise counterparty doesn’t do repo with someone in a deep hole.” Good point about the counterparty risk (and contradicts Ridpath’s assertion). But lets remember that repo is an exchange of value. If you deliver securities, you get cash in exchange.
  • In a reference to the LTRO, the article said “Faced with a situation in which the lack of collateral is starving the financial system of the instruments it needs to do business, the ECB agreed to offer unlimited three-year funding against collateral in two tenders starting today.” The LTRO removes collateral from the system. We wonder if the system is starved for collateral, then why would removing it be the answer?
  • The LTRO allows banks to fund assets that are usually not otherwise fundable in the non-official repo market. For example, packages of loans are securitized and the eligible pieces used as collateral. The repo markets have, understandably, gotten more picky about the instruments they take. This leaves European Banks with dead collateral…unless they can shift it to the ECB. And the three year term is a nice bonus.
A link to the article is here.

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