Hoenig says nix the bankruptcy exemption for mortgage-backed repo



Thomas M. Hoenig, the president of the Federal Reserve Bank of Kansas City, says in a May report that the special bankruptcy treatment extended to mortgage-backed repos in 2005 must be reversed to prevent future financial crises.

In 2005 Congress said repo lenders can keep mortgage-backed collateral if their repo borrower goes broke. That means these repo lenders go to the head of the line when creditors queue up to collect from a bankrupt company.

Hoenig says he believes that if repo lenders are subject to the “automatic stay” rule – which prohibits most creditors from trying to collect ahead of others – they will be less likely to pull out of their repo agreements precipitiously and drive their repo borrowers toward bankruptcy, as they did in 2007 and 2008.

From Hoenig’s report:

We believe the threat of runs by repo lenders would be significantly reduced by rolling back the bankruptcy law for repurchase agreement collateral to the pre-2005 rules.

Hoenig says he does not agree with some economists that FDIC-type insurance or a government guarantee should be applied to repo.

We see no reason why the government and taxpayer should step in and insure positions taken by sophisticated investors with abilities to analyze the risk of securities that back their loans. Therefore, there is no rationale for the government to provide guarantees even in exchange for heavier regulation and supervision of repo markets.

In his May paper, “Restructuring the banking system to improve safety and soundness,” which Hoenig wrote with Charles S. Morris, a Kansas City Fed vice president and economist, Hoenig makes three recommendations for preventing another financial crisis:

(1) Banks should take deposits, make loans, help businesses grow and help individuals manage their money. Banks should not be involved in Wall Street trading, which is much riskier, says Hoenig.

Specifically, in addition to their traditional business of providing payment and settlement services, granting loans, and offering deposits, banks also would be allowed to underwrite securities, offer merger and acquisition advice, and provide trust and wealth and asset management services. They would not be allowed to conduct broker-dealer activities, make markets in derivatives or securities, trade securities or derivatives for either their own account or customers, or sponsor hedge or private equity funds.

However, Noenig notes, if Congress prevents banks from trading, the mega-banks will probably just do the trading in a less regulated subsidiary. So Hoenig also recommends two changes in the less-regulated financial sector, often called shadow banking.

These two changes will lessen shadow banking instability, which is caused by the use of short-term funding for longer-term investment, Hoenig writes.

(2) Money market funds and other investment funds that claim to keep their shares valued at a stable $1 per share, without any reserves or insurance to back up the guarantee, should have to let their share value fluctuate with the market.

(3) Bankruptcy law for mortgage-backed repurchase agreements should be rolled back to the pre-2005 rules, which would make mortgage-related repos subject to the automatic stay in bankruptcy. Repos backed by U.S. Treasuries and other less-risky collateral could maintain the exemption they have had since 1984.

Overall, these two changes to the rules for money market funds and repo would increase the stability of the shadow banking system because term lending would be less dependent on “demandable” funding and more reliant on term funding. Term wholesale funding would continue to be provided by institutional investors such as mutual funds, pension funds, and life insurance companies. While this might increase the cost of funds and, therefore, the cost of mortgages and other consumer loans, it would be less risky and more reflective of the true costs.

Hoenig said he does not agree that bank size should be limited, because no one knows what the maximum size should be.

From the paper, in a section about repo:

One reason for the runs on repo during the crisis was because of the prevalence of repo borrowers using subprime mortgage-related assets as collateral. Essentially, these borrowers funded long-term assets of relatively low quality with very short-term liabilities. The price volatility of subprime mortgage-backed securities (MBS) rose sharply when subprime defaults started reducing MBS income flows. As a result, haircuts on subprime repo rose sharply or the repo was not rolled over.

The eligibility of mortgage-related assets as collateral exempt from the automatic stay in bankruptcy in case of default by the borrower is relatively recent. The automatic stay exemption allows the lender to liquidate the collateral upon default as opposed to having to wait for the bankruptcy court to determine payouts to secured creditors.

Prior to 2005, collateral in repo transactions eligible for the automatic stay was limited to U.S. government and agency securities, bank certificates of deposits, and bankers’ acceptances. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the definition of repurchase agreements to include mortgage loans, mortgage-related securities, and interest from mortgage loans and mortgage-related securities. This meant that repo collateralized by mortgage-backed securities, collateralized mortgage obligations, commercial mortgage-backed securities and collateralized debt obligations backed by mortgage-related assets were exempt from the automatic stay.

Hoenig, who has headed the Kansas City Fed since 1991, is set to retire in October.


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