Friday, December 4, 2009

The Repo Time Bomb Redux

Posted on New Deal 2.0:

On December 2, 2009, the 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 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.

In September 2005, I wrote an article entitled: The Repo Time Bomb, Part II of a multi-part series on Greenspan, The Wizard of Bubbleland, in which I observed:

“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 cash-flow 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 1970’s, 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 “sub-prime” 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 Greenspan 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 US money market. More specifically, banks appear to be actively managing their inventories, to respond to changes in customer demand and the opportunity costs of holding cash, using innovative ways to by-pass reserve requirements. Rising customer demand for new loans is fueled by and in turn drives further down falling credit standards and widens interest rate spread in a vicious circle of unrestrained credit expansion. …”

“… 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 4,000 in 1994 and rose steadily to a bubble of near 12,000, while Greenspan raised the Fed funds rate target seven times from 3% to 6% between February 4, 1994 and February 1, 1995, to try to curb “irrational exuberance.” Greenspan kept the Fed funds rate target above 5% until October 15, 1998 when he was forced to ease after contagion from the 1997 Asian financial crisis hit US markets. The rise in Fed funds rate target in 1994 did not stop the equity bubble, but it punctured the bond bubble and brought down many hedge funds. Despite the Lourve Accord of 1987 to slow the Plaza-Accord-induced fall of the dollar, which fell to 94 yen and 1.43 marks by 1995. The low dollar laid the ground for the Asian finance crisis of 1997 by fueling financial bubbles in the Asian economies that pegged their currencies to the dollar. …”

“… 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, together with the Treasury Department, have evolved from traditionally quiet functions of insuring the long-term value and credibility of the nation’s currency, to activist promotions of 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 that so influenced Bill Clinton, the New Economy president, and Blair, the self-proclaimed neo-liberal market socialist: “nothing is more dissolving of tradition than the permanent revolution of market forces.” What the Third Way revolution did in reality was to restore financial feudalism in the name of progress. Debt has enslaved a whole generation of mindless risk-takers with the encouragement of the wizard of bubbleland. …”

“… 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 October 1, 1998, a month after the collapse of the huge hedge fund: “While their financial clout may be large, hedge funds’ physical presence is small. Given the amazing communication capabilities available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short step from cyberspace. Any direct US regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do in my judgment is what we do today: Regulate them indirectly through the regulation of the sources of their funds. We are thus able to monitor far better hedge funds’ activity, especially as they influence US financial markets. If the funds move abroad, our oversight will diminish. We have nonetheless built up significant capabilities in evaluating the complex lending practices in OTC derivatives markets and hedge funds. If, somehow, hedge funds were barred worldwide, the American financial system would lose the benefits conveyed by their efforts, including arbitraging price differentials away. The resulting loss in efficiency and contribution to financial value added and the nation’s standard of living would be a high price to pay–to my mind, too high a price…”

“… we should note that were banks required by the market, or their regulator, to hold 40 percent 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, 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.”

Whole testimony available here.”

During the weekend of September 13, 2008 a presentation prepared Lehman titled “Default Scenario: Liquidation Framework,” predicted, among other things, that a bankruptcy would trigger a freeze in the broader repo market. “Repos default,” the report read, “Financial institutions liquidate Lehman repo collateral. Repo defaults trigger default of a significant amount of holding company debt and cause the liquidation of hundreds of billions of dollars of securities. Repo collateral caused what might have been the tensest moment of the weekend, according participants.

While poring over Lehman’s mortgage portfolio on 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 what are known as 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, Sept. 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, was extended through Oct. 30.

On the same day, the Fed announced that in exchange for loans it would take the same collateral that private repo counterparties accepted. Instead of demanding only investment- grade securities, the central bank would take the mortgage-backed bonds that had sparked the financial crisis.

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, the short-term financing market that normally was busy as companies renewed their loans, instead was eeriely quiet. No one was lending. Then the entire global market froze.

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