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 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 Louvre 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. ...
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