NY Times on Repo: "After a Financial Flood, Pipes Are Still Broken"

An article appeared in the New York Times on Sunday, Sept. 14th: “After a Financial Flood, Pipes Are Still Broken”, written by Gretchen Morgenson. It is all about repo. And Lehman. It is worth a read but repo professionals are probably going to scratch their heads a bit.

The central themes are:

“…And yet, for all the new regulations governing derivatives, mortgages and bank holding companies, a crucial vulnerability remains. It’s found in our vast and opaque securities financing system, known as the repurchase obligation or repo market. Now $4.6 trillion in size, it is where almost every financial crisis since the 1980s has begun. Little has been done, however, to reduce its risks…”

and

“…In other words, this is a $4.6 trillion arena operating on trust, which can disappear in an instant…

It is disingenuous to say little has been done to reduce Repo’s risks. Tri-party repo reform, while not perfect and still working its way though IT departments, has achieved much. For example, the unwind/rewinds is much shorter in duration than it was and will shrink even more. Three way confirms not only make sure everyone is in agreement on what the trades are, but also allow clearing banks to monitor how a bank is funding itself. Tri-party numbers, including haircuts, are now reported by the Fed, reducing the market’s opacity. Fire sale risk in repo is the next Fed target.

“…Among the biggest participants that provide funding in this market are the money market mutual funds; they lend their cash to banks and other institutions, accepting collateral like mortgage securities in exchange…”

Money market funds, as of 2010, have been subject to more stringent liquidity constraints (and will soon face even more with variable share pricing on some 2a-7 funds). These rules pushed repo maturities, in most cases, to a week or less. Ironically, this has contributed to the vulnerability that Morgenson writes about – that each day there is the opportunity to turn off a repo counterparty.  Protecting both money fund investors and the repo markets often seems at odds with one another.

Liquidity Coverage Ratio (LCR) requirements have done a lot to push repo desk liabilities longer, making them less vulnerable to funding shocks. While LCR rules don’t actually kick in for a while, many major banks have announced they are either in compliance already or very close.

The article never mentions that 70% of the tri-party market is collateralized with US Treasury risk (govies and agencies). In fact the word “tri-party” is never used, much less explained, even though article clearly references JPM and BNYM as clearing agents.

The language seemed spun to support the premise that the repo market is a time bomb waiting to explode. “…In other words, this is a $4.6 trillion arena operating on trust, which can disappear in an instant…” fails to recognize that the transactions are collateralized in the first place, usually with liquid instruments.

“…For decades, the firms had financed their holdings of illiquid and long-term assets — like mortgage securities and real estate — in the overnight repo markets…” Real estate as a repo asset? The actual houses? Really? That would be dumb.

OK. Repo is far from riskless and losing funding will sound the death knell of a broker/dealer. Increasing capital requirements and simplifying the calculations will strengthen the banking system. But this is likely to have an unintended consequence on otherwise low-RWA businesses like Govt repo. Repo businesses won’t be able to charge enough to make the business pay a decent return on all the capital it will attract. Repo desks will gravitate to where they can get paid — with riskier strategies. Or, as the article noted, the business will shrink, which has its own set of unintended consequences.

“…SOME experts think that the answer to the repo problem lies in creating a central clearing platform that would allow all participants, not just the banks, to trade directly. Similar platforms have been mandated for derivatives under Dodd-Frank and could be constructed to support the wholesale funding market…”

Central counterparties for repo does deserve greater study. The recent FBS report “Strengthening Oversight and Regulation of Shadow Banking Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos” (August, 2013) said

“…The FSB believes that there may be a case for welcoming the establishment and wider use of CCPs for inter-dealer repos against safe collateral (i.e. government securities) for financial stability purposes…”

There are some models that might be tweaked and expanded upon – FICC in the US, LCH’s RepoClear and Eurex Clearing in Europe. Only Eurex includes a broad array of market participants, FICC and LCH are inter-dealer only (which is what the FSB advocates for). The FSB also is wary of repo CCPs for paper outside of high quality sovereigns.

As the article said, “such an entity would be a too-big-to-fail institution…” and “…a central clearing platform could be set up as a utility, with officials monitoring transactions and requiring margin payments to finance bailouts in the event of a participant’s default…” If a repo CCP is explicitly set up as a government-backed utility (a concept we think is unavoidable), that will pave the way for a safer (and more highly regulated) repo market. But remember to duck when the politicians get a hold of it.

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