Monday, December 7, 2009

Repo dealers fear legislation will drain liquidity

Posted in the Financial Times by Michael Mackenzie and Helen Thomas:

Wall Street dealers are facing their worst fear as proposed new rules by Congress, designed to protect and bolster the financial system, could have unintended consequences upon a key area of financing for banks and leading financial institutions.

Under a proposal within the Financial Stability Improvement Act, passed by The House Financial Services Committee last week, secured creditors holding collateral from a bank that runs into trouble could end up losing as much as 20 per cent of their claim.

The purpose of the Act is designed to help the Federal Deposit Insurance Corp, which takes over failed banks, to wind up troubled institutions at a minimal cost to the taxpayer. But that has ignited howls of protest from dealers in the repurchase (repo) market, where investors lend cash to banks for short periods of time, thereby giving them an important additional access to finance.

In turn, banks provide collateral that can range from Treasuries and mortgages to corporate bonds, that under the proposed bill could be subject to a 20 per cent ‘haircut’ should the bank run into trouble.

Such a threat could harm liquidity as repo enables investors and dealers to sell bonds without owning them in the hopes that prices fall and yields rise. Being able to borrow bonds in the repo market allows investors to go ‘short’, helping generate a liquid market.

The Securities Industry and Financial Markets Association, an industry body, denounced the plan. “Specifically, we do not support the amendment that would require the FDIC to impose “haircuts” of up to 20 per cent on all secured creditors of an institution in resolution,” said Tim Ryan, president of SIFMA.

One head of repo at a leading bank was blunter, calling the proposed legislation, “nuclear” for the market. He said the industry is finally waking up to the threat, having assumed the legislation would never get this far.

Potentially, the Act, should it become law, could overshadow current efforts among dealers, clearing banks in tri-party repo and investors, who are trying to reform the repo market some time next year.

“If the bill passes and you trade repo with a bank covered under the new rules, the government can take up to 20 per cent of your principal under a bankruptcy,” says Scott Skyrm, senior vice president at Newedge, a repo broker.

For his part, House representative Brad Miller, one of the authors of the proposal, is consulting with the FDIC, Home Loan Banks and the Treasury Department as to whether some securities should be excluded from a ‘haircut’.

”We may exempt Treasuries securities and really then it would limit the effect to more exotic kinds of securities like mortgage-backed securities,” he told the American Banker.

That would appease some critics, who say the bill threatens to alter the safe haven status of Treasuries, by introducing the risk of a loss, should a repo investor hold them as collateral from a troubled bank.

Mr Miller says that legislation is designed to protect the taxpayer by preventing existing creditors in a troubled institution from claiming collateral ahead of others.

Others, however, contend that one of the unintended consequences of such a bill is that it could intensify any future run on a bank using the repo market to fund its balance sheet.

”If the market does not respond to the legislation, then the risk of capital flight for relatively weak institutions (aka a modern bank run) would dramatically increase,” said Ira Jersey, head of US fixed income strategy at RBC Capital Markets.

Prior to the financial crisis, repo financing was used heavily by investment banks. When investors became worried about the health of Bear Stearns and Lehman Brothers, those institutions suffered a run on their repo positions, which contributed to their eventual demise.

As the dust has settled, regulators such as the Federal Reserve have focused heavily on improving the structure of the tri-party repo market. Reforms by dealers and clearing banks are not expected to emerge until well into 2010, but efforts at improving risk management and opertaional issues could be overshadowed by the proposed legislation.

During the crisis, lenders of cash in repo began withdrawing from the market, and that crippled Bear and Lehman which relied on overnight repo to fund half of their financial obligations.

Facing the potential threat of becoming an unsecured creditor means a flight from the repo market could well be a stampede that in the future ends in hours, rather than several days, argue analysts.

”In any situation where it appears that a large firm is about to fail, secured lenders will rapidly head for the exit and terminate as many of their repo transactions as possible,” says Joe Abate, money-market strategist at Barclays Capital.

Such a run could shut down the repo market and trigger an avalanche of failed transactions, which emerged in the wake of Lehman collapsing.

Mr Skyrm says during a future liquidity crisis, investors in the repo market will naturally increase haircuts on collateral, “adding to the liquidity crisis.”

The impact on the repo market is not the only objection being raised.

Bert Ely, head of financial consultancy Ely & Company, argues that the amendment as currently written is too broad and could increase the potential for mismatches in banks’ funding, where they rely on short-term borrowings to fund longer-term lending.

“This will force a shortening of maturities,” says Mr Ely, because greater uncertainty will make long-term funding relatively more expensive.

He adds: “The FDIC has not thought through how markets will respond to this.”

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