Repo in 2012: high quality paper scarce, risker paper increasingly harder to fund

Three recent posts on FT Alphaville all point in a similar direction. If you connect the dots on these cautionary tales, 2012 is going to be a difficult year in securities financing, particularly in Europe. On one side, high quality collateral is in very short supply. This will have knock-on effects to collateralizing central counterparties and bank secured funding in general. At the same time, lesser quality paper is growing more difficult to fund. Dealers and customers alike will be playing it very defensive, hoarding high quality collateral and looking for anyone who has a bid for lower quality paper, preferably for term. 

A Dec. 1 post by Izabella Kaminska Draghi: “We are aware of the scarcity of eligible collateral” quoted the ECB’s Mario Draghi from Nov. 18th, when he said “We are aware of the current difficulties for banks due to the stress on sovereign bonds, the tightness of funding markets and the scarcity of eligible collateral” and “In the money market, we see rising spreads between secured and unsecured segments, and a widening of repo prices between different types of collateral.”

A Dec. 5 post by Joseph Coterill entitled “Dexia’s collateral-crunching guarantee” said that the Dexia bailout will require the bank to post collateral. The post noted that Dexia had already utilized as much collateral as it could already, else they would have gone to the ECB repo facility to raise liquidity. Dexia is said to have executed collateral transformation trades – taking in illiquid paper in exchange for better quality securities – putting Dexia squarely on the wrong side of the trade when funding for the riskier paper became scare.

Another post on Dec. 5th, this one again by Izabella Kaminska, “When you depend on collateralised collateral” portends problems for the covered bond market in Europe. The post writes about what happens when the underlying collateral in a covered bond structure (popular in Europe, still less common in the US) isn’t there anymore. Investors in covered bonds have rights to the underlying collateral, but their paper isn’t segregated in the same way as a US-style securitization. As a result, buyers need to watch out for shifts in the issuer’s balance sheet. Either collateral deterioration or maturities in the underlying portfolios may cause stress for the financial institution, which quickly flows down to the covered bond investor. This reminds us of the problems in the sub-prime market where investors couldn’t get a clear view of the underlying collateral and had to assume the worst.



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