The repurchase market has become Too Big To Fail

Commentary

From the editor:

Have the U.S. and Europe reached the point where borrowers can not be allowed to default on their debt, and their lenders or investors can’t be forced to eat any losses, if financial institutions are widely using the debt as collateral on the repo market?

Isn’t that what happened in the financial crisis of 2007-2008, with mortgage securities? In Greece, with Greek debt? And in the U.S. debt ceiling talks, with Treasuries?

In each case, governments propped up collateral to prevent a repo meltdown.

It appears that the repurchase market has become too big, and too interconnected, to fail.

In the past 25 years the repurchase market has become the essential place that financial markets create credit and central banks conduct monetary policy. Since at least the collapse of the Long-Term Capital Management hedge fund in 1998, governments and central banks have shown they will do whatever it takes to protect the repurchase market and the flow of credit.

What are some of the implications of this development?

– Investors who are lucky enough to have their holdings favored by the repo market get this invaluable protection free of charge. These investors are often big commercial and investment banks and money market funds.

– The market forces that should make lenders careful about who they give money to are weakened. These lenders are also often big commercial and investment banks and money market funds.

– The market for credit default swaps is distorted, because government will artificially protect some securities from default.

– Fannie Mae and Freddie Mac, or some version of them, are not likely to disappear. Without their securities as bulletproof repo collateral, the U.S. repurchase market and the flow of credit would tumble by about one-third, or nearly $1 trillion.

– If the U.S. reduces its debt – and therefore doesn’t need to sell as many Treasuries, to get money to pay its bills – the repurchase market will need to find another source of repo collateral.  This could be risky. The last time the U.S. had budget surpluses and was issuing fewer Treasuries, 1998-2001, repo borrowers stepped up their use of mortgage securities. That, as we know, did not end well.

Repos have been important to U.S. finance for many years. The Federal Reserve has used them since 1917, and they’ve been popular with financial institutions since the early 1950s, according to a 2006 report by Kenneth Garbade, a New York Fed vice president.

As U.S. debt grew, producing a flood of  Treasuries that could be used as repo collateral, so grew the repurchase market, said Garbade.

Currently more than 93 percent of U.S. repo transactions use government-guaranteed securities for collateral, based on the activity of the 20 largest dealers. RepoWatch estimates between $2.3 trillion and $4.7 trillion of credit is issued every day on U.S. government-insured collateral, 31 percent of it thanks to Fannie and Freddie.

Although the U.S. repurchase market has been vital to the credit markets for decades, it really took off after Congress said repos had to be repaid before most other creditors in a bankruptcy proceeding, and after the Federal Reserve encouraged the creation of the modern tri-party repo market in the U.S.  These developments made more collateral available, and they made repurchase agreements easier, cheaper, more efficient and safer to use.

Specifically:

– In 1984 Congress passed a law that exempted repos from a repo borrower’s bankruptcy if they were collateralized by Treasuries, federal agency securities like Fannie  Mae, bank certificates of deposit and bankers’ acceptances. In other words, repo lenders who held these types of collateral were repaid before other creditors in a repo borrower’s bankruptcy.

– In 1985 the Federal Reserve started the development of today’s tri-party repo market, which has become popular as an efficient way to repo, with a clearing bank handling the mechanics of the transactions for borrowers and lenders.

– In 1998 tri-party repo began offering a new service called GCF (General Collateral Finance) Repo, which added another element of efficiency because it accepted any kind of qualified security as collateral, rather than requiring a certain security.

– In 2005 Congress passed a law that exempted repos collateralized with mortgage-related securities from a repo borrower’s bankruptcy. This further popularized using home loans, and derivatives based on home loans, as repo collateral and extended the housing bubble.

Today, countries around the world are developing repurchase markets. When these worldwide repo markets become interconnected, it’s not clear how regulators will manage the systemic risk that was so virulent in the U.S. and Europe in 2007 and 2008..

Mary Fricker
Editor, RepoWatch

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Related story by Gillian Tett for the Financial Times: State is now dominant force in US capital markets