FASB plans to update the repo to maturity rules, but will they go too far and impact liquidation risk?

A January 15, 2013 article in the WSJ by Michael Rapoport “Leeway on Repo Rules Is Cut Back” is worth a read. The Financial Accounting Standards Board (FASB) is proposing to change the repo to maturity rules, eliminating the loopholes that MF Global and Lehman wiggled through. But be careful what you wish for.

We have never understood the repo to maturity rules. Accounting for the trade as a sale didn’t make any sense. A sale means that whatever happens after the sale of the underlying securities, it’s not your problem. But in repo-land, it could be counted as a sale even though you are still responsible for margin calls. If the underlying bonds default, the loss hits the sellers’ books – even though they have “sold” them. And any coupon still comes back to the seller, interest on the cash to the buyer.

But repo accounting has always had some overtones of schizophrenia. Repos to maturity aside, repo deals appear on the books and records as collateralized loans. That is to say only a loan is recorded, not the underlying collateral. Yet repo desks can rehypothecate paper to their hearts content and, in the case of a default, a non-defaulting party can unwind in a flash. These are not characteristics of collateralized lending, where, in a default, everyone is typically stayed until the court figures out what is what and collateral stays put. That aspect of repo walks and talks more like purchases and sales. Repo lawyers like to use purchase and sale terminology when addressing issues like default; the accountants use the collateralized loan language.

Some regulators have, from time to time, raised the issue of the instant liquidation as a factor that contributed to fire sales during the financial crisis. There was a suggestion that mortgage-backed paper might be removed from this regime and now go through a long drawn out legal proceeding. From the Finadium paper “The New Face of the Repo Market for Investors, Dealers and Clearers” (July, 2011)

“…Thomas Hoening, President of the Federal Reserve Bank of Kansas City, has suggested that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which extended the exemption from an automatic stay in bankruptcy to mortgage- related assets, ought to be repealed. Hoening has argued that the ability to quickly liquidate mortgage-related collateral was a factor in the collapse of shadow banking and a cause of the financial crisis. By imposing a stay on liquidation, the process will slow down to a legally-driven snail’s pace. It is unclear if this would help or simply postpone the inevitable…”

There is a thin line between removing repo to maturity abuses and pushing repo firmly into the world of collateralized lending. We are not saying that is where the FASB is taking the market; just to be careful about opening up a can of worms. If credit people had to assume a court ordered stay before they could unwind a trade with a defaulted counterparty, then the VaR timeframe would end up measured on months, not days. The result would be dramatically higher haircuts to absorb the worst-case risk.

If the FASB is changing the repo to maturity rules, they should make sure that synthetic repos – total return swaps and the like – are also included.

And we can’t help but note astonishment on what the Bankruptcy examiner found in MF Global’s books: “…In fact, Mr. Giddens found, the firm’s repo-to-maturity trades actually ended two days short of the pledged securities’ maturity…” How didn’t the auditors catch that? 

A link to a synopsis of the Finadium paper “The New Face of the Repo Market for Investors, Dealers and Clearers” is here.

A link to the WSJ article (which at this writing was not behind the paywall) is here.

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