A shortgage of trusted repo collateral is slowing the flow of credit in the U.S. and in Europe, and that trend is showing up in a survey of the repo market now being conducted quarterly by the Federal Reserve.
Spotting this trend shows how important it is to keep a close eye on the repurchase market. Before the financial crisis of 2007-2008, the repo market could have told us that financial leverage was skyrocketing. But we weren’t looking.
Even now, little is known about repo operations. But the Fed survey is a start. It collects traders’ views of “securities financing” (repo and securities lending) and derivatives, and its most recent report revealed that the nation’s key credit managers were experiencing a tighter supply of all types of repo collateral except stocks.
Responses to questions on securities financing pointed to a tightening of some of the terms under which a broad spectrum of securities were financed, although terms on equities financing were little changed.
These responses stood in contrast with prior surveys in which responses had generally indicated an easing of terms.
In contrast with prior surveys, respondents indicated that liquidity and functioning of all underlying asset markets covered by the survey (with the exception of equities) had deteriorated over the past three months.
The survey was published October 11, covering June through August. The Fed’s next survey, due early next month, should show if the trend is continuing to the end of this year.
Remarkably, the Fed survey is the only official overview of leverage and risk in the U.S.’s vital shadow banking* sector, where money is borrowed and lent outside of traditional banking.
(Thanks to Izabella Kaminska at the Financial Times, the doyenne of repo reporters, for writing a column that alerted RepoWatch to the survey, which the Fed began publishing in July 2010.)
The collateral shortage is in part a result of the failure to reform the repurchase market. After the debacle of 2007-2008, lenders need to know that the repo and securities lending* markets have been reformed and can be trusted. Until then, they’re being very particular about the kinds of collateral they will accept.
True repo reform would create reliable collateral within a framework of stable repo oversight, perhaps along the lines proposed by economists Alistair Milne, Gary Gorton, Zoltan Pozsar, or Viral Acharya.
Without reform, either central banks will have to keep credit moving by accepting second-rate collateral from banks, or credit will stagnate until some clever finance whiz comes up with the next generation of flim-flam securities that the financial markets can embrace.
A shortage of collateral, after all, was a key driver of the housing bubble from 2004 through 2006, as traders created securities out of ever-riskier loans and derivatives, so they’d have more collateral for more borrowing and more trading.
Quality collateral is also needed for the securities lending, derivative, and asset-backed commercial paper markets.
RepoWatch hopes U.S. business editors have assigned reporters to cover the new Fed survey – called the “Senior Credit Officer Opinion Survey on Dealer Financing Terms” – every quarter when it comes out.
Its purpose is to provide “a qualitative picture of changes in credit conditions in the wholesale credit markets that are key conduits for leverage in the financial system.” It tracks whether leverage and credit availability are rising or falling in the shadow banking sector.
Regulators gather the information by surveying senior credit officers at 20 Wall Street dealers, who handle almost all of the securities financing transactions in their industry and much of the derivatives trading, according to the Fed.
In the survey, regulators ask the credit officers to detail changes in their financing activities, including tolerance for risk, use of short- and longer-term credit, acceptance of various types of collateral, and relationships with counterparties.
Check out this great question. The Fed asks the credit officers to tell how the use of financial leverage has changed over the past three months for each of the following: Hedge funds, mutual funds, exchange-traded funds, pension plans, endowments, insurance companies and investment advisors.
Wouldn’t that have been useful information in 2005 and 2006?
A reporter who studies the Fed survey, along with some data reports – weekly primary dealer, monthly tri-party, quarterly Flow of Funds, and quarterly company reports to the FDIC and the SEC – should be able to spot important developing trends in the U.S.
Hopefully, the Office of Financial Research, created by the Dodd-Frank Act to collect data that will help regulators spot rising systemic risk, will one day publish bucketloads of information. But that appears to be years away.
Other news from the Fed’s new third-quarter survey included:
-The appetite to bear risk declined somewhat over the past three months for all types of market participants.
-About one-fifth of dealers reported an increase in spats with other dealers and hedge funds over the value of the transaction or the collateral, in both securities financing and derivative deals. These disagreements may have been related to increased market volatility and to concern about developments in Europe, researchers said.
-About one-fourth of Real Estate Investment Trusts that invest in mortgages instead of real estate said their use of leverage has gone up since the beginning of the year.-
-About 15 percent of credit officers noted an increase in demand for Treasuries or a deterioration in the liquidity and functioning of markets using Treasury collateral.
The Fed survey is modeled after a 47-year-old survey of commercial banks that regulators have long valued as a window into credit conditions in the traditional banking sector.
Market participants discussed in the Fed’s new survey include broker-dealers, central clearinghouses, hedge funds, REITs, mutual funds, exchange-traded funds, pension plans, endowments, insurance companies, separately managed accounts established with investment advisers, and nonfinancial corporations.
Collateral discussed in the Fed survey includes high-grade corporate bonds, high-yield corporate bonds (that is, junk bonds), stocks, residential and commercial mortgage-backed securities including those that are insured by Fannie Mae or Freddie Mac and those that are not, and asset-backed securities backed by consumer loans like credit cards and automobiles.
Fed officials described their reason for instituting the survey:
The financial crisis, however, also highlighted that a significant volume of credit intermediation had moved outside of the traditional banking sector and emphasized the importance of the “shadow” banking system in the provision of credit to businesses and households and as a conduit for leverage and maturity transformation in the financial system. Moreover, instruments closely associated with the shadow banking system—including OTC derivatives and securities financing transactions—contributed to the buildup of risk prior to the crisis and to the transmission of financial distress across seemingly separate parts of the financial system during the crisis.
There is also a broad consensus that an erosion of credit terms applicable to such instruments had the effect of enabling greater leverage in the years leading up to the crisis. However, because little or no systematic data was available on credit terms in wholesale markets, the buildup of risks was not as obvious at the time as it is in hindsight. Clearly, having a better perspective on the sources of leverage employed in the financial system outside of traditional banking institutions, and how these change in importance over time, is a necessary prerequisite for action, whether by policymakers or market participants, to deal more promptly with such situations in the future.
Reporter Kaminska noted that Deutsche Budnesbank, Germany’s central bank, said in its November 2010 Financial Stability Review that a similar survey might be useful in Europe, where more information about repos is also needed.
In the run-up to the ﬁnancial crisis, the expansion of the shadow banking system was closely linked to the favourable conditions applying to wholesale money market funding. Apart from (asset-backed) commercial paper, this, above all, includes the secured repo market. The rapid withdrawal of liquidity provided by repos (repo run), whereby parts of the shadow banking system also came under pressure, resulted in many intermediaries encountering additional difﬁ culties and was therefore a major channel of contagion in the ﬁnancial crisis. This makes it necessary to obtain a better insight into the scope, structure and ﬁnancing situation of the repo market, given its importance as a source of funding. …
There is, to date, not enough information available speciﬁcally on international network connections. This is especially true of the segment for secured money market transactions, known as repos. Repo markets are key to liquidity management and represented one of the central channels through which shocks were transmitted during the crisis. More over, changes in behaviour on repo markets can also be used as a timely indicator for a loss of conﬁdence in an individual ﬁnancial institution or in the ﬁnancial system as a whole. Qualiﬁed information on the structure of and activity on repo markets is therefore needed. In the second quarter of this year, the US Fed introduced a new quarterly survey on changes in credit terms and conditions for securities ﬁnancing and over-the-counter derivatives transactions, which could serve as a model for the euro area.
Other reading on collateral shortages:
“IMF’s Singh warns of collateral drought threat to global liquidity,” Euromoney, December 21, 2011.
We have tracked a $5 trillion reduction in global source collateral and associated chains. These are big numbers.
(RepoWatch editor’s note: Imagine how scarce good collateral would be today without Fannie Mae and Freddie Mac, the mortgage giants that Democratic and Republican leadership in Washington want to close. Their taxpayer-backed securities currently are the collateral for one-third of daily U.S. repurchase transactions by the nation’s largest dealers, or $900 billion a day. If you want to know why the thoroughly discredited Fannie and Freddie still exist, look no further.)
“Bonds Stop Flowing as Collateral Gets Stuck at ECB: Euro Credit,” Bloomberg, December 21, 2011.
Faced with a situation in which the lack of collateral is starving the financial system of the instruments it needs to do business, the ECB agreed to offer unlimited three-year funding against collateral in two tenders starting today.
“The decline of ‘safe’ assets,” Financial Times, December 5, 2011.
As was perhaps inevitable, the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.
“Velocity of Pledged Collateral: Analysis and Implications ,” by Manmohan Singh, IMF senior economist, November 2011.
Large banks and dealers use and reuse collateral pledged by nonbanks, which helps lubricate the global financial system. … Post-Lehman, there has been a significant decline in the source collateral for the large dealers that specialize in intermediating pledgeable collateral. Since collateral can be reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral) may have been a $4-5 trillion reduction in collateral.
“The Committed Liquidity Facility,” Australia’s central bank explains Australia’s approach to the collateral-shortage problem, November 23, 2011. As Kaminska reports, this is similar to the Federal Reserve’s Supplementary Financing Program, which has been in operation since September 17, 2008.
The Basel liquidity standard requires that banks have access to enough high-quality liquid assets to withstand a 30-day stress scenario, and specifies the characteristics required to be considered an eligible liquid asset. The issue in Australia is that there is a marked shortage of high quality liquid assets that are outside the banking sector (that is, not liabilities of the banks).
“Europe’s banks strike funding deals,” Financial Times, November 23, 2011
UK-based banks are providing strained European lenders shut out of global funding markets with large amounts of financing through privately negotiated asset-swapping deals. The deals struck include “term repos”, where banks offer longer-term financing in exchange for illiquid assets.
“No Love Lost for U.S. Debt as Bond Dealers Share Fewer Treasuries With Fed,” Bloomberg, May 31, 2011.
Treasuries are in such short supply in the $4.9 trillion-a- day repurchase agreement market used by dealers to finance their holdings that investors are lending cash for next to nothing to obtain the bonds. The average level of overnight general collateral repo rates fell as low as 0.01 percent on May 5. About a third of government securities transactions in the repo market trade below zero percent, according to Barclays Plc data.
Repo rates may move further below the Federal funds rate when the central bank begins lifting borrowing costs. The Fed’s so-called effective rate, a weighted average of trades between major brokers, was 0.09 percent on May 26, according to ICAP Plc data.
“Everybody wants more collateral and Treasuries are the best collateral in the world,” according to Stanford University professor Darrell Duffie, who serves as a member of the Federal Reserve Bank of New York’s financial advisory roundtable.
“You’d think that the world would be awash in Treasuries as the U.S. is issuing more than they ever have,” said Duffie, who studies credit risk, asset pricing and the over-the-counter derivatives as the Stanford Graduate School of Business’s Dean Witter Distinguished Professor of Finance. “But everybody wants them.”
*Shadow banking is where financial companies borrow and lend outside the safety net of FDIC insurance and the Federal Reserve discount window. Much of the borrowing and lending is done on the repurchase market. Shadow bankers include money market funds, securities broker-dealers, investment and commercial banks and their holding companies, finance companies and mortgage brokers, issuers of asset backed securities (ABS) and asset backed commercial paper (ABCPaper), derivative users, hedge funds, off-the-books businesses variously known as trusts, special purpose entities, special purpose vehicles, variable interest entities, conduits, or structured investment vehicles and any other kind of financial company that borrows short term and lends long term outside the federal financial safety net. Economists sometimes call shadow banking the wholesale credit markets or parallel banking.
*Securities lending is a smaller cousin to the repo market, where financial institutions lend mostly stocks in return for cash.