NYU: Most of the leverage was in repos

“Repo financing was the basis of most of the leveraged positions of the shadow banks.”

From RepoWatch’s view, that’s the key sentence in “Regulating Wall Street,” a November 2010 book authored by New York University Stern School of Business professors Viral V. Acharya, Thomas F. Cooley, Matthew Richardson, and Ingo Walter.

The important sentence appears in Chapter 11, “The Repurchase Agreement (Repo) Market.” It’s on page 332 of the book’s 529 pages. It’s hard to understand why it’s so buried.

If excessive leverage at financial institutions was the reason the mega-banks had to be bailed out, as almost everyone agrees, doesn’t it seem that more attention to that leverage is warranted?

That said, the repo chapter in “Regulating Wall Street” is illuminating. Some passages from the chapter:

By the fourth quarter of 2009, the amount of outstanding securitized debt in the United States totaled $11.6 trillion, about one-third of the entire U.S. debt market. Much of the securitized debt is in the form of what are called repurchase agreements. …

No official statistics of the actual size of the repo market have been collected since inclusion of almost all types of securitized debt as collateral was allowed in repo agreements. Therefore, there is no official information on the evolution of the size of the repo market over the past quarter century. …

Despite its central role in the shadow banking system – and in the recent financial crisis – there was almost no mention of the repo market in the … Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. In this chapter, we explain why the silence about dealing with the possibility of future runs in the repo market is a significant mistake. In particular, we explain that, unlike the liquidity risk that unsecured financing may become unavailable to a firm, the liquidity risk that secured repo financing may become unavailable to a firm is inherently a systemic risk: The repo markets are likely to become illiquid precisely when a large part of the financial sector is experiencing stress. Unless this systemic liquidity risk of the repo market is resolved, the risk of a run on the repo market will remain.

In this chapter, we provide a primer on the U.S. repo market, describe how it came to play such a significant role in securitized banking, discuss its critical role in the form of repo runs in the crisis, argue a case for reforming the repo market infrastructure based on an understanding of the fundamental source of repo runs, outline our proposal for such reform, and articulate implications for the future.

Another illuminating section for RepoWatchers is pages 229-231, about the effect of the Bankruptcy Act of 2005 on the repurchase market.

In 1984, a new law said repo lenders could keep certain collateral if a repo borrower went bankrupt, unlike most creditors who have to share loss with other creditors. In 2005, the Bankruptcy Act added repo loans collateralized with mortgages and interests in mortgages to the list of repos that were exempt from a borrower’s bankruptcy.

Critics claim the bankruptcy exemption (1) lets repo lenders ignore risk and makes them eager to do more repo loans, (2) makes repo borrowers ravenous for more collateral, so they can get some of those repo loans, (3) lets banks get by with less equity because regulators think a bank that is selling securities overnight on the repurchase market, to get a repo loan, is taking less risk that if it holds the same securities longer term, and (4) artificially drives down the value of repo collateral, when repo lenders rush to sell collateral they’ve had to seize.

From “Regulating Wall Street”:

The original motivation for the qualified financial contracts’ (repos, swaps, forwards, some other derivative contracts) special status in the bankruptcy code was to reduce the systemic risk in the financial system.  … however, the reduction in systemic risk due to qualified financial contracts avoiding the automatic stay (and related provisions) in bankruptcy is replaced by another form of systemic risk involving fire sales of qualified financial contracts and liquidity funding spirals.

Specifically, consider the sale and repurchase or repo agreements. Many repo financiers are money market funds subject to restrictions on average maturity of their investments. When they face default on a repo of a long-term asset such as mortgage-backed security, their (typically overnight) role as a lender in a repo financing gets translated into being the holder of a long-term asset. As a result, the financier may be forced to liquidate the asset upon a repo counterparty’s failure. … In the current cisis, there was considerable angst that a bankruptcy of large, complex financial institutions like AIG, Merrill Lynch, or Citigroup would have forced large amounts of mortgage-backed derivatives to be sold on the marketplace. Given widespread exposure to these securities by other financial institutions, these losses would have caused a funding liquidity issue, causing even more sales and losses, leading to a death spiral of large parts of the financial system.

An equally strong argument against the safe harbor is that it creates regulatory arbitrage within the system. Specifically, counterparties can build up large concentrated exposures without much consequence, and, because most qualified financial contracts can be transformed to mimic the underlying asset, there exist two classes of claims with essentially the same economic purpose, yet subject to different rules and thereby having different implications for ex ante risks.

By way of example, consider again a repo against an AAA-rated mortgage-backed security. If the mortgage-backed security is held on the banking book of a large, complex financial institution, it gets treated as a long-term holding subject typically to capital requirement against one year’s potential credit risk. If the mortgage-backed security is instead on the trading book as an available-for-sale security that is being rolled overnight in repo markets, then it would be treated as being sold and repurchased each day, so that it would be subject to only one day’s market risk as far as its capital requirement goes. … Effectively, the migration of the mortgage-backed security from the banking to trading book lowers the capital requirement against it throughout the system …

Such distortions push counterparties toward designing complex products that can help shift assets from the banking to the trading book, which are then financed using short-term repos in the shadow banking system, away from the monitoring of regulators and at substantially lower capital requirements. …

The expansion of safe harbor to repo transactions with underlying mortgage-based assets in the Bankruptcy Act of 2005 has been cited as one of the reasons for the growth in mortgage-based derivatives over the period from 2005 to 2007.


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