Fed says not so fast to Fitch's research saying riskier assets making a come back in repo

A post on the New York Fed’s Liberty Street Economics blog by Antoine Martin caught our eye. Entitled “Is Risk Rising in the Tri-Party Repo Market?” it refutes a research report from Fitch that claimed that the collateral used in tri-party repo had been deteriorating. Martin used data from the Tri-Party Repo Infrastructure Reform Task Force “…to show that there is in fact no evidence of a broad-based increase in riskier types of collateral…”

The Fitch report drew their conclusions based on trades done by large money market funds; their sample accounted for 5% of the market. The Liberty Street Economics post’s sample was 100% of the market and benchmarked riskier collateral, defined as anything other than US Treasuries or US government sponsored entities, at just over 15% of the market. The trend, if anything, for this percentage has been falling, not rising. Even when broken out into investment grade corporate bonds, non-investment grade corporate bonds, private label CMOs, ABS, and equities, the answer is the same: no discernable increase in the percentage market share for any of these asset classes.

Martin also looked at haircuts. If riskier assets were increasing in tri-party, it might be reasonable to conclude that lower haircuts were making them more attractive. But haircuts haven’t changed either, with the exception of a recent spike upward in private label CMO and ABS.

Then why did Fitch find what they did? Perhaps the sample was not indicative of the broader market? Large MMFs may not be a representative sample, perhaps skewed toward higher quality broker/dealers. Tri-party cash lenders have traditionally focused more on the counterparty risk than the collateral risk. This is unfortunate, especially given that the tri-party reform is pushing the collateral risk more in the cash lender’s court.

We wrote a post on February 6, 2012 entitled “Déjà vu All Over Again: risky assets making a comeback in repo?” when the Fitch report came out. A link is here. In our post we said, “…We do wonder how appropriate it is to extrapolate out to the rest of the market from the 5% or, put another way, how idiosyncratic the large Money Market funds tri-party investing strategy is relative to the rest of the market…” and counseled caution on riskier collateral.

Anecdotal evidence supports the Fed’s conclusions. A comment on our post from Jeff Kidwell at AVM stated, “…We do not see the repo market moving back to pre-Crisis levels on riskier securities, CDOs and RMBS. In fact, a couple of notable dealers have been talking about reducing their exposure and/or exiting the market altogether…” and “…Dealers also recognize that it is going to be way too expensive to be in this space, given the regulatory costs coming from Dodd-Frank and Basel III…” Jeff makes a good point: there just isn’t much supply of the riskier paper out there.

 A link to our February post on the Fitch report is here.

 A link to the Liberty Street Economics blog post is here.

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