Tett: Silence on repo reform is “shocking”

On the second anniversary of the collapse of Lehman Brothers, forced into insolvency by its repo lenders demanding more collateral or refusing to renew their loans, little has been done to reform the repurchase market, writes Gillian Tett, U.S. managing editor of The Financial Times, in a September 23 column.

Tett is author of “Fool’s Gold,” a book about the development of credit default swaps and synthetic collateralized debt obligations, which fueled the housing bubble in part by becoming collateral for financial institutions to make an endless supply of repo loans to each other.

Tett notes that the task force of bankers convened by the New York Fed to reform the tri-party repurchase market issued a 43-page report four months ago, describing problems with the market. The New York Fed published a written response and called for reform. Since then, there’s been silence.

Tri-party, where JP Morgan and Bank of New York Mellon stand in the middle to broker and clear trades, handles about one-fourth of U.S. repurchase transactions. In the crisis, regulators’ primary concern was the safety of the tri-party market.

The task force of bankers recommended steps to protect JP Morgan and Bank of New York Mellon, but it conceded it did not come up with a way to protect markets from a repo panic.

JP Morgan and Bank of New York have no interest in expanding regulation of the market because they enjoy “enormous informational power” from the status quo, Tett writes.

From Tett’s column:

Both reports almost immediately vanished from public view. They were not, for example, mentioned in all the US Congress summer debates. Indeed, the Dodd-Frank bill barely touches them at all. And, this month, as European and US regulators have marked the second anniversary of the collapse of Lehman Brothers by unveiling new financial reforms, the issue has barely cropped up at all.

Perhaps this is unsurprising: after all, until 2008 the workings of the repo market – or the part of finance where banks raise short-term loans backed by collateral – seemed distinctly dull.

But in many ways this silence is shocking. After all, the sector is huge: the total volume of so-called “tri-party repo contracts” – or those arranged via a third-party broker – in the US peaked at about $2.8 billion in early 2008 and is now at about $1.7 billion.

Moreover, the repo market was central to the dramas of 2008. One of the main reasons why entities such as Lehman Brothers collapsed, after all, was that investors fled from repo deals, because they became frightened about counterparty risk. They also feared that the collateral backing these deals was losing value, particularly in relation to mortgage bonds, which represented 37 per cent of collateral.

… the structure of the tri-party market is so closely entwined that it creates a contagion risk as bad as anything seen in the derivatives world. But while this contagion issue is now prompting politicians to push derivatives activity on to a clearing house, there have not been similar demands in the repo world.

Meanwhile, as the repo market in the U.S. remains dormant, in Europe it’s now bigger than it was in 2008. In part, that’s because the economy is improving and European regulators are starting to implement some repo reforms aimed at making repo more transparent and less risky, Tett writes.

From Tett’s report:

However, the core vulnerability that was exposed during the Lehman shock has still not gone away. The key problem is that there is still no neutral, third-party platform to underpin deals – and guarantee that they are honoured – if disaster strikes. …

Is there a solution? Some observers, such as Viral Acharya, a New York-based economist, argue that what is needed is a type of neutral clearing house or resolution mechanism. This would, in effect, guarantee to complete deals in a crisis and thus avoid any damaging firesales of collateral. It would also avoid the need for the government to provide an implicit backstop for JP Morgan and Bank of New York Mellon as the private sector clearing banks (which is what they are basically doing right now since they cannot afford for these to fail).

Tett is not optimistic that reform is imminent.

That sounds extremely sensible. But it seems most unlikely to happen anytime soon. Indeed this idea is not even properly discussed in those May reports.

One reason is that JP Morgan and Bank of New York Mellon have a vested interest in maintaining the status quo, since it gives them enormous informational power.

The other problem is that there is little political appetite right now in the US or Europe for any more upfront, explicit state guarantees to the financial sphere. Unless a repo resolution mechanism is backstopped by, say, a central bank, it is unlikely to be credible. Little wonder, then, that silence rules.

Right now it is easier for everyone to keep crossing their fingers – and pray that JP Morgan and Bank of New York Mellon remain bulletproof for years to come.


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