UK regulators warn of dangers in repo mutations

Repurchase transactions are morphing into riskier forms of collateralized lending, the Bank of England warned in its June 2011 Financial Stability Report.

With interest rates continuing at record lows, financial institutions and other investors are looking for ways to juice their returns, and various forms of collateralized lending are attractive because the collateral appears to protect the lender in case of default.

The Bank of England report, and a June 30 Financial Times story about it, are important peeks into where the next repo-related dangers may develop.

Under scrutiny in the report are collateral swaps and synthetic exchange traded funds. As with repos, regulators feel they don’t know enough about these transactions.

From reporter Jennifer Hughes’ story in the Financial Times:

The risk for bank regulators is that these deals are yet another hard-to-monitor route for banks to obtain funding against their illiquid assets.

The Bank fears, in the case both of synthetic ETFs and collateral swaps, that unidentified and heavy use of the deals could surprise regulators if a bank were to suddenly run into trouble if the markets took fright.

In the U.S., the Dodd-Frank Act created the Office of Financial Research to collect data so regulators would not be surprised like this in the future, but so far the bureau hasn’t even decided what information to collect.

In a speech June 29, Paul Tucker, deputy governor of the Bank of England, urged British bank regulators to watch for new ways that shadow banking might finance itself, including collateral swaps and synthetic ETFs.

The authorities have not done enough, in my personal view, to encourage robust practices in repo and securities lending markets. That is likely to form part of the Financial Stability Board’s work on shadow banking.

The broader point here is that the Financial Policy Committee will try to nip incipient problems in the bud. If only someone had taken action to contain the mutation of securitisation a decade ago.

To understand collateral swaps and synthetic ETFs, and how they might be destabilizing, it helps to first understand repurchase transactions and securities lending, repo’s smaller cousin, and their role in the financial crisis of 2007-2008.

All of these deals – repo, securities lending, collateral swaps, and synthetic ETFs – are collateralized ways for financial institutions to borrow money, so they can use it to make more money, without having to use their own cash. The credit crisis in 2008  happened mainly when financial institutions suddenly had to pay back their repo and securities lending debt – because the lenders decided they didn’t trust the mortgage collateral – and couldn’t.

In a repurchase transaction, the borrower gets cash and gives bonds to the lender as collateral, promising to repay the loan when it comes due, often the next day, by buying back the bonds.

Securities lending is the same, except that the collateral is stock and the deal is structured as a loan, not as a purchase/buy-back.

A collateral swap is the same, except that the borrower gets easier-to-sell bonds like U.S. Treasuries, instead of cash, and as collateral the lender gets harder-to-sell bonds like mortgage-backed securities. The borrower can then use the easier-to-sell bonds to collateralize a repo loan or to get cash in other ways.

From the Financial Times:

In essence, collateral swaps are simply a form of secured lending where one party lends liquid assets, such as top-rated government bonds, to another and in return receives less liquid collateral to mitigate the risks.

The Bank is concerned with a growing number of such private deals being struck between banks and investors such as insurers. … the private nature of many such deals is making it tougher for regulators to know the genuine exposure of any particular bank or insurer.

A synthetic ETF is the same, except that the borrower gets cash from an exchange-traded fund, gives the fund some collateral, and promises to pay the fund the returns that the fund tracks.

Collateralized lending generally has the support of bank regulators, because the collateral appears to give lenders a measure of protection, but it is controversial among some economists.

Economist Carolyn Sissoko, for example, worried that collateralized lending lulls lenders into a false sense of security and makes them think they don’t have to do much – if any – underwriting.

From Sissoko’s “The legal foundations of financial collapse” published October 6, 2009:

Financial markets are likely to be healthier when uncollateralized contracts are the norm. In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty.

Many derivative contracts, such as credit default swaps, are also secured by collateral. 

RepoWatch congratulates the Financial Times for its consistent reporting on repo and related ways that financial institutions build up debt, or leverage. The U.S. press rarely writes about the repurchase market, and as a result its uninformed readers may not be able to assess developing dangers going forward.