The US debt uncertainty starts to affect repo, and we are getting concerned

The lunacy in Washington over a possible US debt default is now manifesting in the repo markets, and repo is the canary in the coal mine. This is a troubling sign and one that could create a much, much bigger problem if not resolved shortly. It seems that policymakers do not remember how Lehman went into bankruptcy. We present some current evidence and a possible scenario of what happens if this very sorry state of affairs continues.

The Evidence
– Money market funds are getting skittish and selling off treasuries that have the shortest maturities. The yield on one month treasuries has risen from .028% to .484% in recent days, according to a MarketWatch report. This is in spite of the fact that, as Sue Hill at Federated notes, “Securities and Exchange Commission Rule 2a-7, which governs money market funds, does not require that a fund dispose of a security that is in default. Rather, it permits the fund to continue to hold such a security, provided that the board of directors of the fund has determined that disposal of the security would not be in the best interests of the fund.” Clearly, many MMF managers don’t care – they would rather just exit now than deal with “technically defaulted securities.”

– Multiple sources report that repos backed by one month treasuries have risen to between 23 and 40 bps, a higher yield than overnight repos backed by longer term paper and for GC trades through the end of the year. This upside down market is in turn pushing up yields on agency MBS repo. In a flat interest rate world, its a bad sign when shorter term debt is riskier than longer term debt.

– We hear that cash providers are backing off repos supported by one or even two month treasuries. This is a partial shut down of one section of the repo market. Even though banks can substitute other collateral, the basic idea of some of the world’s once-best collateral being now unacceptable to cash providers is both astounding and a real concern. These are supposed to be the securities that a cash provider would want most in a repo default as they should be the easiest to liquidate. No need to think about repo collateral fire-sales, this is repo collateral no-sales. We have to wonder, will the Fed’s own SOMA program accept technically defaulted treasuries as collateral in exchange for collateral that cash providers will more readily accept? Hard to know right now.

A Bad Scenario
While we believe and hope that no US debt default will occur, we think it is important to point out what happens in times of crises of confidence: this is when markets freeze up. We remind readers that Lehman Brothers was fully funded and was a going concern – right until just a few days before it failed. Here’s a chart from the Federal Reserve that shows the speed of the repo funding drop off:

Lehman Brothers tri-party repo financing

Nervous cash providers can get worried about a rumor that any one bank might have insufficient assets, and that could stop all repo with that bank, leading to bankruptcy and a forced try-out of the Orderly Resolution Authority before all the kinks are sorted. Since financial markets are largely based on sentiment, this would certainly freeze credit markets worldwide and require government intervention on a massive scale to get moving again. Forget nascent recoveries – this would be a quick return to the dark ages.

Although stock market indices seem to be the most appealing indicator to policy makers that their actions have real consequences in financial markets, the warnings of the repo market, and the lessons of Lehman Brothers, should also be taken very seriously.

There are rare occasions when we at Finadium wish we had a bigger pulpit to stand on, but this is one of them. And we aren’t the first people to make this call – see a Bloomberg article from October 7 with similar themes. But we think the points must be reiterated. This is a major, man-made disaster in the making with warning signs already apparent. Policy makers need to act now to ensure that repo, the grease of financial markets, remains a robust funding mechanism. Getting this wrong would have dire real world impacts.

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