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Repo time-bomb redux
By Henry CK Liu
On December 2, 2009, the US House Financial Services Committee approved a bill
to regulate systemic risk in financial markets which, aside from proposing a
new systemic regulator, includes a little-noticed
proposal that when any large bank fails in the future, it should be placed into
a resolution regime, with creditors losing up to 20% of the value of the debt.
While haircuts are normally part of any restructuring, haircuts have never been
applied to the repo (or repurchase) market, where
banks raise short-term funds by lending out assets. The
new rule would destroy the repo market as a low-cost
source of borrowed funds. "The implications will be horrendous ...
doing this would be madness," the Financial Times quoted what it said was
the head of one large bank as saying.
The repo market is one in which two participants
agree that one will sell securities to another and make a commitment to repurchase equivalent securities on a future specified
date, or on call, at a specified price. In effect, it is a way of borrowing or lending stock for cash, with the stock
serving as collateral.
To put the committee's move in context, a review of the repo
market and its role as detailed in observations I made in September 2005, are
still only too relevant. (See The repo time bomb, part 2 of a multi-part series,
Greenspan, The Wizard of Bubbleland)
:
"The repo
market is the biggest financial market today. Domestic and international repo markets have grown dramatically over the last few
years due to increasing need by market participants to take and hedge short
positions in the capital and derivatives markets; a growing concern over
counterparty credit risk; and the favorable capital adequacy treatment given to
repos by the market.
"Most important of all is a growing awareness among market participants of
the flexibility of repos
and the wide range of markets and circumstances in which they can benefit from
using repos. The use of repos in financing and leveraging market positions
and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full participation in today’s
financial markets. ... Unless the repo market is
disrupted by seizure, repos can be rolled over easily
and indefinitely. What changes is the repo rate, not the availability of funds. If the repo rate rises above the rate of return of the security financed
by a repo, the interest rate spread will turn
negative against the borrower, producing a cashflow
loss. Even if the long-term rate rises to keep the interest rate spread
positive for the borrower, the market value of the security will fall as long-term
rate rises, producing a capital loss. Because of the interconnectivity of repo
contracts, a systemic crisis can quickly surface from a break in any of the
weak links within the market. ...
"... Mortgage-backed securities are sold to mutual funds, pension funds,
Wall Street firms and other financial investors who trade them the same way
they trade Treasury securities and other bonds. Many participants in this
market source their funds in the repo market. ... In
this mortgage market, investors, rather than banks, set mortgage rates by
setting the repo rate. Whenever the economy is
expanding faster than the money supply growth, investors demand higher yields
from mortgage lenders. However, the Fed
is a key participant in the repo market as it has unlimited funds with which to buy repo
or reverse repo agreements to set the repo rate. ...
" ... As with other financial markets, repo markets are also subject to
credit risk, operational risk and liquidity risk. However, what
distinguishes the credit risk on repos from that
associated with uncollateralized instruments is that repo
credit exposures arise from volatility (or market risk) in the value of
collateral. For example, a decline in the price of securities serving as
collateral can result in an under-collateralization of the repo.
Liquidity risk arises from the possibility that a loss of liquidity in
collateralized markets will force liquidation of collateral at a discount in
the event of a counterparty default, or even a fire sale in the event of
systemic panic.
"Leverage that is built up using repos can exponentially increase these risks when the
market turns. While leverage facilitates the efficient operation of financial
markets, rigorous risk management by market participants using leverage is
important to maintain these risks at prudent levels. In general, the art of risk management has been trailing the decline of
risk aversion. Up to a point, repo markets
have offsetting effects on systemic risk. They can be more resilient than
uncollateralized markets to shocks that increase uncertainty about the credit
standing of counterparties, limiting the transmission of shocks. However, this
benefit can be neutralized by the fact that the use of collateral in repos withdraws securities from the
pool of assets that would otherwise be available to unsecured creditors in the
event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they can transmit
shocks originating from this source. Finally, repos
allow institutions to use leverage to take
larger positions in financial markets, which adds to systemic risk. ...
"... Created to raise funds to pay for the flood of securities sold by the
US government to finance growing budget deficits in the 1970s, the repo market has grown into the largest financial market in the world,
surpassing stocks, bonds, and even foreign-exchange. ... The repo market grew exponentially as it came to be used to
raise short-term money at lower rates for financing long-term investments such
as bonds and equities with higher returns. The derivatives markets also require
a thriving financing market, and repos are an easy
way to raise low-interest funds to pay for securities needed for arbitrage
plays.
"It used to be that the purchase of securities
could not be financed by repos, but those
restrictions have long been relaxed along with finance deregulation. Repos were used first
to raise money to finance only government bonds, then corporate bonds and later
to finance equities. The risk of such financing plays lies in the
unexpected sudden rise in short-term rates above the fixed returns of long-term
assets. For equities, rising short-term rates can directly push equity prices
drastically down, reflecting the effect of interest rates on corporate profits.
...
"... The runaway repo market is another
indication that the Fed is increasingly operating to support a speculative
money market rather than following a monetary policy ordained by the Full
Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act.
... Commercial banks profit from using
low-interest-rate repo proceeds to finance
high-interest-rate "subprime" lending -
credit cards, home equity loans, auto loans etc - to borrowers of high credit
risks at double digit interest rates compounded monthly.
"To reduce their capital requirement, banks then remove their loans from
their balance sheets by selling the CMOs
(collateralized mortgage obligations) with unbundled risks to a wide range of
investors seeking higher returns commensurate with higher risk. In another era, such
high-risk/high-interest loan activities were known as loan sharking. Yet
[Alan] Greenspan [in 2005, the Federal Reserve chairman] is on record for
having said that systemic risk is a good trade-off for unprecedented economic
expansion. Repos are now one of the largest and most
active sectors in the
"... A repo squeeze occurs when the holder of a
substantial position in a bond finances a portion directly in the repo market and the remainder with 'unfriendly financing'
such as in a tri-party repo. Such squeezes can be
highly destabilizing to the credit market. The direct dependence of derivatives
financing on the repo market is worth serious focus.
According to Greenspan, "by far the most significant event in finance
during the past decade has been the extraordinary development and expansion of
financial derivatives. ... At year-end 1998, US
commercial banks reported outstanding derivatives contracts with a notional
value of only $33 trillion, less than a third of today's value, a measure that
had been growing at a compound annual rate of around 20% since 1990. Of the $33
trillion outstanding at year-end 1998, only $4 trillion were exchange-traded
derivatives; the remainder were off-exchange or over-the-counter (OTC)
derivatives. Most of the funds came from the exploding repo
market. ...
"... By 1994, Greenspan was already riding on the back of the debt tiger
from which he could not dismount without being devoured by it. The Dow was
below
"... Yet
in detached language and calm tone, Greenspan has been saying that he does not
intend to exercise his responsibility as Fed Board chairman to regulate OTC
financial derivatives intermediated by banks, even though he recognizes such
instruments as being certain to produce unpredictable but highly-damaging
systemic risks. The justification for no-regulation is: if we don't smoke at
home, someone else offshore will. Moreover, risk is a price we must accept for
a growth economy.
"It sounds like that the Fed expects that each market participant or even
non-participant individually to take measures of self-protection: either miss
out on the boom, or risk being wiped out by the bust. It is unpatriotic, not to
mention dumb, not to participate in the great American game of downhill racing
risk-taking.
"With the rise of monetarism, the Fed [and] the Treasury Department have
evolved from traditionally quiet functions of insuring the long-term value and
credibility of the nation’s currency, to activist
promoters of a speculative boom fueled by run-away debt, replacing the
Keynesian approach of fiscal spending to manage demand by sustaining
board-based income to moderate the downside of the business cycle. Never
before, until Greenspan, has any central banker advocated and celebrated to
such a degree the institutionalization and socialization of risk as an economic
policy.
"As Anthony Giddens, director of the London
School of Economics, explains in his The
Third Way, which so influenced president Bill Clinton, the 'New Economy'
president, and [then British prime minister Tony] Blair, the self-proclaimed
neo-liberal market socialist: 'Nothing is more dissolving of tradition than the
permanent revolution of market forces.' What the
"... In a speech on financial derivatives before the Futures Industry
Association in Boca Raton, Florida on March 19, 1999, Greenspan said: 'By far
the most significant event in finance during the past decade has been the
extraordinary development and expansion of financial derivatives ... the fact
that the OTC markets function quite effectively
without the benefits of the Commodity Exchange Act provides a strong argument
for development of a less burdensome regime for exchange-traded financial
derivatives.' ...
"... Greenspan testified on the collapse of Long-Term Capital Management
(LTCM) before the Committee on Banking and Financial Services, US House of
Representatives on
"Greenspan continued: '… we should note that were
banks required by the market, or their regulator, to hold 40% capital against
assets as they did after the Civil War, there would, of course, be far less
moral hazard and far fewer instances of fire-sale market disruptions. At
the same time, far fewer banks would be profitable, the degree of financial
intermediation less, capital would be more costly, and the level of output and
standards of living decidedly lower. Our current economy, with its wide financial safety net
[what would this be? FDIC, SIPC, Too-Big-to-Fail, Taxpayer bailouts, FASB neutering, …?], fiat money,
and highly leveraged financial institutions, has been a conscious choice of the
American people since the 1930s. We do not have the choice of accepting
the benefits of the current system without its costs.' The whole testimony can
be obtained here."
During the weekend of September 13, 2008, immediately before Lehman Brothers
filed for bankruptcy on September
While poring over Lehman's mortgage portfolio that Saturday, a Goldman Sachs
partner, Peter S Kraus, accused JPMorgan chairman Dimon of being too aggressive in demanding more collateral
and margin from other banks to cover declining values. JPMorgan, as a clearing bank, holds collateral for other banks in
tri-party repo transactions. When
the value of the collateral declines, JPMorgan can
require a borrower bank to post more or higher quality assets so the lending
bank is protected.
The Fed was sufficiently anxious about a standstill in repo
funding that on Sunday, September 14, it temporarily modified Rule 23(a) of the
Federal Reserve Act to allow banks to use customer
deposits to fund securities they couldn't finance in the repo
market. That change, scheduled to expire in January 2009, was extended through
October 30 this year.
On the same day,
The Fed arranged for Lehman's broker-dealer unit to remain open after the
bankruptcy filing to allow for repo deals to be
resolved in an orderly way.
On Monday morning,
Henry C K Liu is chairman of a New York-based private
investment group. His website is at http://www.henryckliu.com.
(Copyright 2009