There have been a couple articles recently about the tri-party fire sales and higher market share of equity tri-party repo. Lets connect some of the dots.
Two of the articles appeared in Bloomberg and were written by Liz Capo McCormick. On February 12th there was “Fire Sale Risk Climbs With Equity-Backed Repo Rise, Fitch Says” and on February 13th McCormick penned “New York Fed Says Repo Fire Sale Risks Not Being Addressed”. A third was in Reuters on February 11th “Fitch: Tri-party drops again but equity repos at record high”. The articles made reference to a Fitch report, dated December 20, 2013 “Repos: Market Decline Amid Policy Risk” (sorry, behind a subscriber wall). Finally the Fed released a statement on February 13th: “Update on Tri-Party Repo Infrastructure Reform”.
The articles circle back to the Fed’s jawboning about fire sales. So far it has only been speeches, conferences, and academic research – but the volume of the rhetoric had steadily gone up and proposals can’t be too far away.
From the Fed statement:
“…A third policy imperative that the Federal Reserve has long highlighted—namely the risk of destabilizing fire sales of repo collateral by tri-party repo investors in the event of a default of a large tri-party repo borrower—is not currently being addressed by industry participants. The risk of post-default fire sales is not unique to tri-party repo, but is a particular concern in the tri-party repo market given the composition of its investor base. Many tri-party repo investors are highly vulnerable to liquidity pressures and credit losses that may cause them to liquidate the collateral of a defaulted counterparty very quickly, even if they must do so at a loss. The ensuing price declines could trigger margin calls and deleveraging well beyond the repo market, spreading instability across the financial system. Unfortunately, no mechanism currently exists or is being developed to ensure that investors will act collectively and in a measured way in liquidating their collateral. Fire sale risk remains a critical policy concern of the Federal Reserve and other members of the U.S. regulatory community. As noted by Federal Reserve Bank of New York President Dudley in a recent speech, in the absence of a market-based solution to this risk issue, regulators may be forced to use the tools they have to take steps to reduce this risk…”
Lets look how equity repo fits in. From the Reuters piece:
“…The sharp 40% yoy increase in equity repos takes the outstanding volume to USD149bn or almost 10% of all tri-party repo collateral, according to recent figures from the Federal Reserve Bank of New York (FRBNY). This is the highest level since the data series started in May 2010, with growth accelerating in the month to 10 January 2014 (up 11%)…”
and from the February 12th McCormick piece, where she interviewed Robert Grossman of Fitch:
“…“One reason for the equity-backed repo increase is because of the higher yield available on them, that is, from the lenders perspective,” Robert Grossman, managing director of macro credit research at Fitch in New York said in a telephone interview yesterday. “All other things being equal, in a distressed market the nongovernment collateral can have more liquidity issues. One of the policy issues on the horizon is fire-sale risk”…”
The articles noted that equity repo haircuts have been steady at 8% through the year.
So why are equity repos growing? Fitch’s Grossman was right: yield. From the Reuters article:
“…repos backed by US Treasury and agency MBS securities continued to decline, as these more “rate-sensitive” forms of collateral collectively fell by about USD59bn over the past month and by more than USD350bn since January 2013. The shift to riskier forms of repo collateral partly reflects continuing low yields. For example, as of end-August 2013, repos backed by equities in the tri-party market yielded 35bp, compared with about 11bp yield on agency repos…”
A missing piece here is where this equity repo is a new phenomenon or a shift from the traditionally equity-driven prime brokers financing world. But there should be no surprise that repo traders are jumping for joy to earn 35bp on equity repo versus considerably less on more liquid assets. Do budgets for repo desks shrink when their balance sheets are clipped? Not so much. This forces desks to push toward higher yielding business to make up the shortfall.
As an aside, we have even heard about clients looking for leverage on CLO equity pieces. The CLO market has been dislocated; largely a result of the Volcker Rule, and paper has made its way to leveraged investors. CLO Equity pieces are, by their residual nature, leveraged already – so it is pretty dangerous to lend against. But dealers might consider the business because they look liquid now and there is a lot of profit to be made. Is it starting to remind anyone of RMBS repo circa 2007~08?
So with tri-party fire sales on the Fed’s mind and repo dealers increasingly embracing more volatile collateral, how will all this end? Not well.