Sunday, February 9, 2014

Sunday extra credit: Repo edition

REPO, REPO, REPO:  Repo up the Wazoo. Repo til you can't see straight. Repo til the cows come home.

The experts unanimously agree on one fact: The 2008 meltdown began in Repo.

Will 2014 be the year of the "repeat"?

Check Repowatch for updates

"The financial crisis was not caused by homeowners borrowing too much money. It was caused by giant financial institutions borrowing too much money, much of it from each other on the repurchase (repo) market. This matters, because we can't prevent the next crisis by fixing mortgages. We have to fix repos." Mary Fricker,  Repowatch

“The money market fund industry and the repo market is really the major fault line that goes right under Wall Street." -- Dennis Kelleher, CEO of Better Markets,, July 24, 2013.
Repo: "The silently beating heart of the market." -- Treasury Borrowing Advisory Committee, July 2013.
Under Basel capital rules, "repos among financial institutions are treated as extremely low risk, even though excessive reliance on repo funding almost brought our system down. How dumb is that?" -- Sheila Bair, chair of the Systemic Risk Council and 2006-2011 Chair of the FDIC, June 9, 2013

Wall Street’s One-Night Stands; Someone Could Get Hurt in Repo Market” by David Weidner, The Wall Street Journal MoneyBeat, Writing on the Wall, May 29, 2013:
“The repo market wasn’t just a part of the meltdown. It was the meltdown.”

1--Why you should worry if U.S. defaults, Mary Fricker  (Repowatch), Santa Rosa Press democrat

Early next year, when Congress once again threatens to default on U.S. debt, you are going to hear more predictions of doom. Should you be concerned? Yes.

Let me explain this by going back to 2008. That year, as home values tanked, the financial markets erupted into a full-blown crisis. This happened for the same reason that experts warn of disaster if the U.S. defaults on its debt: The repurchase market failed.

Likely you never heard of the repurchase market. What is it?

Simple. It's where giant financial institutions in the U.S. and Europe borrow $7 trillion from one another, every day, often just for overnight. That's $7 trillion. Every day. Just for overnight.
The main borrowers are the world's biggest banks. They use this borrowed money to make investments and loans throughout our economy. The main lenders are money market funds.

Other players are large mortgage companies, investment banks, corporations, insurance companies, pension plans, university endowments, municipalities and anyone with a big pool of money to lend.
If this market freezes, as it did in 2008 and might do again in the event of a U.S. default, the flow of credit throughout the country is dramatically impaired. What can make the repurchase, or “repo,” market freeze?

That's where mortgages and U.S. debt come in. To get a repo loan, a financial institution has to put up some collateral, usually pools of mortgages or U.S. debt called Treasuries. If the lender decides it doesn't like the collateral, it won't make the loan. Since repos are very short-term loans, often just for overnight, repo lending can stop on a dime and the repurchase market can freeze in a matter of days.
That's what happened in September 2008. Repo lenders lost faith in the mortgages they'd been taking as repo collateral. They stopped lending. Giant financial institutions could not get money.

Federal Reserve Chairman Ben Bernanke told Congress that in September and October of 2008, “Out of maybe the 13 most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.”

This is what turned a real estate bubble into the worst financial crisis since the Great Depression. Could it happen again, for example if lenders lose faith in Treasuries? You bet.

If you've read this far, let me admit I've vastly oversimplified the repo story. Interesting things happen on that market.

For example, collateral can be reused. If a borrower puts up $100 million in Treasuries as collateral for a repo loan, the repo lender can use those same Treasuries as collateral to get a repo loan for itself, and the next lender can use the same Treasuries as collateral to get a repo loan for itself.

Usually these are overnight loans that the lenders renew the next day. But imagine how interesting it gets when one of the lenders in the chain wants its money back. Why is this market called the “repurchase” market? Because transactions take the legal structure of a purchase. The borrower “sells” its collateral to the lender and promises to “repurchase” it soon, often the next day.

The Fed conducts much of its monetary policy on this market. When you read that the Fed may soon start selling the securities it bought during the recession, what the Fed will actually do is use those securities as collateral for a repo loan. Then the lender to the Fed can use those same securities as collateral.

Congress should not be messing with the repurchase market.

2---After a Financial Flood, Pipes Are Still Broken, NYT
"a $4.6 trillion arena operating on trust, which can disappear in an instant. "

Is our financial system safer and sounder today than it was back then?

...for all the new regulations governing derivatives, mortgages and bank holding companies, a crucial vulnerability remains. It’s found in our vast and opaque securities financing system, known as the repurchase obligation or repo market. Now $4.6 trillion in size, it is where almost every financial crisis since the 1980s has begun. Little has been done, however, to reduce its risks.
The repo market, also known as the wholesale funding market, is the plumbing of the financial system. Without it, money could not flow freely, and banks, brokerage firms and asset managers would not be able to conduct their trades and open for business each day.
When institutions sell securities in this market, they do so with the promise that they can be repurchased the next day — hence the “repo market” name. By using this market, banks can finance their securities holdings relatively cheaply, money market funds can invest cash productively and institutions can borrow securities so they can sell them short or deliver them in other types of trades.
Among the biggest participants that provide funding in this market are the money market mutual funds; they lend their cash to banks and other institutions, accepting collateral like mortgage securities in exchange. The money market funds accept a small amount of interest on these overnight loans in exchange for being able to unwind the transactions daily, if need be.

When markets are operating smoothly, most wholesale funding trades are not unwound the next day. Instead, they are rolled over, with both parties agreeing to renew the transaction. But if a participant decides not to renew because of concerns about a trading partner’s potential failure, trouble can arise.
In other words, this is a $4.6 trillion arena operating on trust, which can disappear in an instant. ...

“It was a very unstable form of funding during the crisis and it is still a problem,” said Sheila Bair, former head of the Federal Deposit Insurance Corporation, and chairwoman of the Systemic Risk Council, a nonpartisan group that advocates financial reforms, in an interview. “The repo market is also highly interconnected because the trades are done between financial institutions.” ...

Peter Nowicki, the former head of several large bank repo desks, is an advocate of this idea. “Repo is the last over-the-counter market that’s not headed toward central clearing and the Fed should mandate a change,” he said. “Should a large dealer have a problem or the clearing banks have an issue, the repo market could shut down.”
And that, five years after the Lehman collapse, would be an unconscionable failure.

“I can’t imagine that the Fed wouldn’t find a way to keep the markets liquid in the event of a default,” he said. “The Fed has got some pretty robust contingency plans.”

Treasuries are widely held and have long been used to help put values on all sorts of other financial assets, from corporate loans to mortgages. They also underpin trades in the $600 trillion derivatives markets. As a result, doubts about what Treasuries are really worth could reverberate deeply through the system....

Even if a fiscal deal is reached soon and a default is avoided, investors around the world may view American sovereign debt as tainted for some time. Some of the same difficulties that came with the European debt crisis may linger in America.
“It’s hard to think about a well-functioning financial system and economy when your risk-free asset is under threat,” said Jacques Cailloux, chief European economist at Nomura.

Still, ordinary banks appear better protected than they were in 2008.
They hold substantially more capital, the financial buffer they need to absorb losses. A deep recession caused by a government default would certainly damage the banks in many ways. But they appear adequately insulated from any losses on Treasuries. Banks in the United States held $166 billion of Treasuries at the end of June, according to figures from the Federal Deposit Insurance Corporation, a primary bank regulator. By comparison, they had $1.63 trillion of capital.

Activities outside traditional banking look more exposed, though.
Wall Street firms and their clients, for instance, borrow trillions of dollars through the so-called repo market. In this market, large investment banks borrow for very short periods from investors with spare cash, pledging assets like Treasuries as collateral for the loan. They use the market to finance the purchase of securities.

In 2008, the repo market froze. The Fed rushed in to support the market with enormous credit lines to banks. Since then, regulators have introduced measures to strengthen the repo market, but they say they want to do more.

Treasuries back one-third of all transactions done in the $2 trillion repo market that brokers use the most. A violent sell-off in Treasuries could reduce the value of the collateral that brokerage firms use in repo, making it difficult for them to do business.

If the repo system was impaired, it would be “very dangerous for the largest dealers because they might be unable to find financing for their securities,” said Darrell Duffie, a professor of finance at Stanford.....

One often-identified flaw in the repo market is that it depends on cash provided by money market funds, the investment vehicles that individuals often think of as safe places to park their cash. The mutual fund industry has taken steps to gird the money funds. Even so, regulators continue to press for further measures.
The threat of small losses in the money market funds — perhaps from defaulted Treasuries — could prompt many investors to withdraw their money.
“Even if the funds do prepare themselves, they can’t control it if their customers are pulling money out of the funds,” said Scott Skyrm, a former Wall Street trader who writes a blog on the repo market

4---Repo markets prepare for operational risks amid U.S. default fears, Reuters

5---Why US bonds matter to global markets and you, AP

Treasury market is considered the cornerstone of the global financial system.
Q: The "cornerstone of the global financial system?" That seems a bit excessive, don't you think?
A: It's not excessive at all.
Investors weight risk in deciding what to invest in and for how long. Risk determines how much they should be paid for placing their trust in an investment. Risk, in other words, is simply the chance that an investment will not pan out as expected.
Investors treat U.S. Treasurys as a sort of "zero point" that all other investments are calculated against. Even when a solid company like Apple issued debt to pay its bills, Apple is considered relatively more risky than the debt of the United States.
The risks of all financial instruments in the U.S. (and many around the globe) are calculated against the risk of buying U.S. Treasurys. This includes mortgages, bank rates, credit card interest rates, other bonds, etc.
Money market funds have to hold extremely safe investments because investors expect to get every dollar they invest back. Right now, this short-term debt is too risky for these funds.
It's no surprise that investors get nervous every time politicians debate raising the U.S. debt limit.
The stock market is the better-known barometer of the U.S. financial system, symbolized by famous companies and colorful traders on the floor of the New York Stock Exchange. But the $38 trillion bond market is a far larger and more important driver of world financial markets.

And at the center of it all: the market for U.S. Treasurys. Treasurys play a crucial role in the global economy. They allow the U.S. to borrow cheaply to pay its bills and influence rates on home mortgages and many other kinds of loans....

The United States is the largest debtor on the planet, owing roughly $12 trillion to public investors....

a U.S. default may impact bank-to-bank lending.
Banks often use Treasurys as collateral when they borrow from other banks. This "repo" market is massive, roughly $5 trillion by some estimates, and is used by nearly every bank to fund day-to-day lending. Signs have emerged that some banks and money market funds have stopped accepting U.S. Treasurys as collateral, or are requiring more collateral to borrow.
That has started to affect lending.

6---If It Looks Like a Bank, Regulate It Like a Bank , Bloomberg

There’s ample evidence that extreme leverage presents a threat to markets and the economy -- and zero evidence that it provides any benefits.
“Shadow banking” is really a misnomer. Regulators know what’s going on and understand the threat it poses. They ought to stop discussing the problem and start acting to solve it.

In this shadow realm, other forms of short-term borrowing such as shares in money-market mutual funds play the role of deposits. Securities dealers, hedge funds and other financial firms buy longer-term assets such as bonds backed by mortgages or corporate loans. They employ the assets as collateral against further loans, which they get from money-market funds, banks and one another. The collateral gives creditors a guarantee they’ll be repaid.

The shadow banks’ leverage is limited mainly by the amount of money they can borrow against a given amount of collateral. Before the crisis, they could borrow $97 against each $100 in mortgage-backed securities -- a “haircut” of 3 percent, the equivalent of putting just $3,000 down on a $100,000 home loan. Such high leverage amplifies risk: If the price of the security falls just 3 percent, the creditor’s margin of safety is wiped out.

The 2008 crisis demonstrated just how fragile the shadow-banking system can be. Worries about mortgage bonds caused prices to plunge, rendering all kinds of leveraged investors -- including investment banks such as Bear Stearns Cos. and Lehman Brothers Holdings Inc. -- insolvent or unable to finance their investments. The Lehman bankruptcy, in turn, triggered a run on money-market funds, further draining the system of the liquidity it needed to function.

How can this system be made more resilient? Mark Carney, the new governor of the Bank of England, offered a sense of what regulators are thinking in a speech last week: Give shadow banks the same access to emergency central-bank loans that traditional banks enjoy. This is a dangerous idea, with the potential to produce the kind of speculative boom that would end very badly. Imagine the risks investors would be willing to take if they knew the central bank would always provide cash if private lenders balked.

Granted, Carney noted that this expansion of public insurance would have to be accompanied by expanded regulation, but he was vague about it. What he should have said is this: If an entity engages in banking activity, and hence is vulnerable to runs with potentially systemic consequences, it must register as a bank, with all the backstops and capital requirements that entails.

7---Taking the Bus on the Road to Default, WSJ

Treasurys are the collateral of choice in both the $2.6 trillion "bilateral repo" market and the $1.8 trillion "tri-party repo" transactions. Those two are building blocks of banks' short-term financing and their ability to funnel money to the economy. U.S. government debt also is widely used in the giant derivatives market.
The collapse of Lehman showed what happens when derivatives and repo markets lose faith in collateral: financial deals and world trade grind to a halt because counterparties no longer trust each other.
The impact of any of this could, of course, be cushioned by rescue actions. Traders and bankers say the Federal Reserve could ease the liquidity squeeze by stepping into the repo markets or even buying defaulted Treasurys. But that is more of a hope than a belief. The Fed has indicated its unwillingness to intervene.
The message from Wall Street to Washington is clear: Unless there is a lasting deal we are on a one-way bus to a very scary place.

as New York Fed President William C. Dudley noted in his recent introductory remarks at the conference “Fire Sales” as a Driver of Systemic Risk, “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales.” For example, in a time of market stress, when margin calls and mark-to-market losses constrain liquidity, firms are forced to deleverage. As recently pointed out by our New York Fed colleagues, deleveraging could impact other market participants and market sectors in current times, just as it did in 1763.

Summary: What REALLY happened in 2008:

Higher margins on repo and increased collateral calls due to credit ratings downgrades reduced the quantity of assets that could be financed in repo markets and elsewhere, prompting further asset sales.(6) As wholesale investors started to exit, this set in motion a bad dynamic—a fire sale of assets that cut into earnings and capital. This just increased the incentives of investors to run and for banks to hoard liquidity against the risk that they could themselves face a run. This downward spiral of fire sales and funding runs was a key feature of the financial crisis ...

As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party repo market became increasingly concerned about the liquidity and credit risks that they faced. The clearing banks became uncomfortable with their large intraday exposures to their tri-party securities firm customers. After all, if a securities firm were to fail suddenly, the clearing banks could be stuck with huge loans to these counterparties, secured by securities that were not necessarily high quality and liquid. Thus, as the condition of the most troubled securities firms deteriorated, there was a risk that one morning a clearing bank might decide not to unwind a firm’s tri-party transactions in order to avoid a large intraday exposure.

This risk faced by the clearing banks, in turn, unnerved the tri-party repo investors (many were money market mutual funds). After all, if the unwind did not occur, they would be stuck with the collateral securing their loans from the night before. Most of these investors were not prepared to take possession of and liquidate such collateral, and had no interest in doing so. The incentives for these investors were to run at the first sign of trouble to avoid getting stuck with the dealer’s collateral.
This incentive to run was reinforced by the fact that if the investors were stuck with the collateral, they would have strong incentives to sell it quickly in order to generate the liquidity needed to meet redemption calls or to keep their portfolios in line with regulatory guidelines. Such “fire sales” of assets could result in losses and could be extremely destabilizing to markets....

The crisis also made it clear that the monies provided to the money market mutual funds by their own investors were also inherently unstable. This made such funds, in turn, an unreliable source of finance in repo, commercial paper and other markets....

The second function of a lender of last resort is to prevent the fire sale of assets by firms facing a sudden loss of funding from spreading contagion across the system and disrupting the provision of credit to the economy. This is particularly important during a financial panic, when the demand for liquidity increases sharply. Only the central bank has the ability to meet this increased demand under any potential circumstances....

Which path to go down—limit wholesale funding or backstop it more broadly—would depend in large part on the social value of the capital markets-based activities presently being financed in unstable short-term wholesale markets and the utility of short-term wholesale funding for lenders.....

don’t think we should be comfortable with a situation in which extensive maturity transformation continues to take place without the appropriate safeguards against runs and fire sales....

Wholesale funding as a structural vulnerability....

(It was cheaper, that's why)

Short-term funding of longer-term assets is inherently unstable particularly in the presence of information and coordination problems. It can be rational for a provider of funds to supply funds on a short-term basis, reasoning that it can exit if there is any uncertainty over the firm’s (the borrower’s) continued ability to roll over its funding from other sources. But if the use of short-term funding becomes sufficiently widespread, the firm’s roll-over risk increases. In this situation, there is a strong incentive for each lender to “run” if there is any uncertainty that could undermine the borrower’s ability to continue to roll over its funding from other sources. This is the case even if the provider of funds believes that the borrower would remain solvent as long as it retained access to funding on normal terms......

In the pre-crisis period the growth of securitization was accompanied by a growing reliance on short-term funds raised in wholesale markets to finance securities and activities essential to securitization. This ranged from the use of repo(3) funding to finance inventories of securities held for market-making(4) purposes to the issuance of asset-backed commercial paper by conduits(5) created to acquire and hold securities. (Economists now call this shadow banking.)

The increased use of short-term wholesale finance was driven both by demand and supply factors. On the demand side, it was more profitable to use shorter-term funds to finance longer-term assets. On the supply side, such funding was plentiful because it was viewed as safe and because of the growing institutionalization of savings with corporations and institutional investors in need of deposit-like products in which to place their cash balances. After all, the funds were only exposed for a short period of time, and in the case of repo, secured by collateral.

The growing reliance on short-term wholesale funding to finance longer-term assets increased liquidity (this is the ability to get cash fast) and maturity mismatch risk (this is the risk of borrowing short and lending long). This was particularly dangerous because many of the assets being financed were structured-credit products (these are securities backed by loans, pools of loans and derivatives), some of which were opaque, difficult to value and illiquid.

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