U.S. debt default could freeze repo market


Last updated June 26, 2012

When Treasury Secretary Tim Geithner says a U.S. default on its debt “would inflict catastrophic, far-reaching damage on our Nation’s economy,” one of his key worries is the repurchase market.

That’s because if repo lenders would no longer accept U.S. Treasuries as collateral for repo loans, the $7 trillion-a-day plumbing for the U.S. and European financial markets, and the market where the Federal Reserve daily conducts monetary policy, could freeze again as it did in 2008.

“Those assets (U.S. Treasury securities) may be used as collateral for borrowings, the fuel on which the global markets run. A disruption of this process, even for a day, would have repercussions far into the future,” wrote Randall Forsyth May 18 in Barron’s, in a story headlined “Collateral damage: The true cost of a U.S. default.”

Roughly two-thirds of repurchase agreements are collateralized with U.S. Treasury securities, based on the activity of the 21 biggest dealers. These dealers, thought to represent about 90 percent of the market, had $2.8 trillion in repos outstanding May 11, the most recent day that information is available, and $1.9 trillion of those contracts had Treasuries as collateral, according to dealer reports to the Federal Reserve Bank of New York.

Of course, repos aren’t the only damage that would be done. In a May 13 letter to U.S. Senator Michael Bennet of Colorado, Geithner said a default would mean that the United States, its families, businesses and local governments would have to pay a higher interest rate to borrow money. This would reduce investment, entrepreneurship, job creation and growth. Higher rates would depress an already fragile housing market and increase the federal deficit. The value of U.S. Treasury securities would fall, causing Americans’ savings to lose value. Less economic growth would mean lower tax revenues and less services for those in need. The economy could fall into a double-dip recession.

Why would this happen? From the letter:

The unique role of Treasury securities in the global financial system means that the consequences of default would be particularly severe. Treasury securities are a key holding on the balance sheets of virtually every major insurance company, bank, money market fund, and pension fund in the world. They are also widely used as collateral by financial institutions to meet their day-to-day cash flow needs in the short-term financing market.

In other words, repos.

A default on Treasury debt could lead to concerns about the solvency of the investment funds and financial institutions that hold Treasury securities in their portfolios, which could cause a run on money market mutual funds and the broader financial system – similar to what occurred in the wake of the collapse of Lehman Brothers. As the recent financial crisis demonstrated, a severe and sudden blow to confidence in the financial markets can spark a panic that threatens the health of our entire global economy and the jobs of millions of Americans.

As we can see, the repurchase market still has not been reformed, three years after the financial crisis. The dangers of a run are as acute as ever.

The Barron’s story takes us back to 1982, to an earlier repo scandal.

Tuesday is the 29th anniversary of the failure of Drysdale Government Securities. Long before Long-Term Capital Management went bust in 1998, or Lehman Brothers a decade later, this medium-sized bond dealer’s collapse threatened the underpinnings of a then-shaky financial system.

All three companies failed over dealings on the repurchase market. In the case of Drysdale:

Chase Manhattan Bank, Drysdale’s counterparty on the repo transactions, had to pony up the $160 million Drysdale owed. Ultimately, Chase wound up losing $270 million on its dealings with Drysdale. (Chase then was a very different entity from today. A diagram of fish eating other fish might be helpful, but years later Manufacturers Hanover was swallowed by Chemical Bank, which later merged with Chase, which in turn was taken over by JP Morgan.)

Chase took the hit for its miscreant customer. The principals of Drysdale Government Securities ultimately pleaded guilty to securities charges, but it was Chase that had to pay in order that the repo market — on which the entire financial edifice is built — continued to function.

Forsyth fears the Drysdale tale is too arcane to interest many readers, but he writes about it anyway because it’s important.

All of which is trivia that interests bond geeks and nobody else. But the real relevance is the key role that Treasury securities play in funding the financial system, which may not be fully appreciated. And that may be the greatest danger if the game of chicken over the debt ceiling goes over the cliff and the Treasury defaults.

Thanks to editor Paul Muolo at National Mortgage News for letting RepoWatch know about the Forsyth story, a rare example of U.S. reporters writing about the repurchase market.


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