Will removing repo safe harbors fix systemic risk? This paper thinks so….

At the Fed’s Workshop on the Risks of Wholesale Funding on August 13th, there were presentations on repealing the repo safe harbor. This is an idea that has gotten some momentum lately, but we think it isn’t such a great idea. We look at a paper presented at the conference “Rolling Back the Repo Safe Harbors” by Edward  R. Morrison, Mark J.Roe, and Hon. Christopher S.Sontchi.

First, what is meant by the repo safe harbor? This is the provision that allows creditors to liquidate collateral when a borrower defaults. Often when there is a bankruptcy, the case ends up in negotiations and court proceedings. (By the way, we are not lawyers…can you tell?) The lender cannot liquidate any of the bankrupt entity’s assets before the court gives their approval. One effect this has is to prevent fire sales. The liquidation process slows down. Although there is no guarantee that prices will be better when the assets are eventually sold, the idea is that the process is less disruptive with fewer externalities. Anyone following the fire sale debate on tri-party knows that these externalities – the risk that other parties will be hurt simply because the lender wants to get out of the collateral ASAP and may accept a lower price than might be obtainable in a calmer market – weighs heavily on the Fed.

From the paper:

“…Special rules  exempt  an increasingly wide arc of creditors from the normal  operation of bankruptcy. These so‐called“safe harbors” exempt the bankrupt debtor’s financial‐contract counterparties from the basic rules that halt creditor collection efforts when the bankruptcy begins, that claw back preferential and fraudulent pre-bankruptcy transfers that harm creditors overall, and that facilitate orderly liquidation or reorganization. These safe harbors for financial contracts exist for one articulated purpose: to promote stability in financial markets.

Yet there is no evidence that they serve this purpose. Instead,  considerable evidence shows that, when they matter most — in a financial crisis   — the safe harbors exacerbate the crisis, weaken critical financial institutions, destabilize financial markets, and then prove costly to the real economy…”

The authors want to do away with safe harbors for less liquid paper. Treasuries, Agencies backed by full faith and credit, bank Certificates of Deposit and Bankers Acceptances would still have protection – in other words rolling back the world to 1984. They argue that the safe harbor allowed financing of less liquid paper during the crisis that, perhaps, might not have been facilitated if the repo provider knew they were subject to a stay in bankruptcy. In other words, safe harbors made things worse, despite the banks arguing they were a risk mitigant.

The paper suggests that since repos have protection from stays in bankruptcy, it encourages banks to transact repos instead of longer term financing (like loan warehouse facilities) that are subject to stays should the borrower go bust. Since repos are typically short-term arrangements that are more susceptible to market stress & funding shocks, the more borrowers rely on repos, the more systemic risk is in the system.

“…The safe harbors, in other words, encourage less stable financing for our largest and most important financial institutions, making it more likely that a stressed institution will need to liquidate in a costly way. Those who might be prepare to lend long‐term to an important financial institution would, all else equal, be induced by the safe harbors to lend short‐term (via repo) and roll over that repo on a regular basis. They are then incentivized to decline to rollover (to run) in the event of  a financial crisis or in the event of financial difficulty with the borrower. This policy is unwise. It weakens American financial structures and institutions…”

Lehman was used as a case in point: repo credit flowed to Lehman until just before the firm’s collapse, according to the paper, because lenders knew they could liquidate collateral quickly. And when the stress started to become extreme, the repo lines were pulled and dealers refused to roll over trades. Had the extensions of credit to Lehman been subject to bankruptcy stays, the argument goes, perhaps Lehman might have had enough time to work out a rescue.

“…Had Lehman not become so dependent on safe‐harbored  repo—more than  one‐third of its liabilities were said to be in repo—it might have been better positioned to weather  the crisis for long enough for a more stable solution to emerge…”

The knock-on effect of removing safe harbors for repo will be long and painful. If only UST and GNMA paper is covered (including CDs and BAs are a vestige of old rules and seem inappropriate if the proposal succeeds), then Fannie and Freddie paper probably should no longer be HQLA. That will exacerbate collateral shortages and create a bifurcated cash and repo market. Financing anything subject to a stay will either disappear or be subject to very high haircuts. Remember that VaR analysis on repos must take into consideration how long it will take to liquidate the paper and a stay blows those assumptions out of the water.

The article does note that synthetic repos – financing in derivatives clothing – could become a substitute since derivatives also are not subject to stays. Any proposal would have to include equivalent transactions. And then keep being updated to add in the latest funding innovation.

The Fed has said in the past that they were reluctant to mess with bankruptcy law. We wonder if that has changed? 

Just yesterday we did a post on a NY Fed’s Liberty Street Economics blog post on gating money market funds “The Fed’s Liberty Street Economics gets it right on gating and fees to prevent runs: they don’t work.” The authors concluded that gating (and charging large fees to liquidate when a fund is under stress) was a bad idea since it promoted lenders to act pre-emptively as the slightest hint of stress. We wonder if this won’t be the case for repos subject to stays? Dealers won’t lend past overnight and will pull lines at the slightest provocation. This will create self-fulfilling repo runs and systemic vulnerability – if the financing can even be found.

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