FT: Volcker rule may exempt repos and securitization

Repos and securitization, the combination that nearly destroyed the credit markets and the U.S. economy in 2007-2009, will not be prohibited by the Volcker rule, according to the Financial Times.

The Volcker rule is intended to limit proprietary trading at banks, as a way to control risk. Proprietary trading is trading a bank does for its own profit, rather than for a customer. But the Volcker rule, as currently proposed by regulators, will exempt repos and securitization, according to a draft of the rules seen by the Financial Times and confirmed by people familiar with the draft, writer Tom Braithwaite reported.

This means the repurchase (repo) market continues to be untouchable, as regulators, politicians and an industry task force have all failed to rein in the market most responsible for turning a mortgage crisis into a full blown credit panic in 2008.

From the September 18 story:

According to a 174-page draft of the rules seen by the Financial Times, and confirmed by people familiar with discussions between regulatory agencies, so-called “repo” transactions and securities lending, and near-term trading in currency and commodities – but not futures – will be permitted.

The draft rules exempt from the prop trading ban “positions arising under certain repurchase and reverse repurchase agreements or securities lending transactions [and] bona fide liquidity management”. They also allow “positions in loans, spot foreign exchange or commodities”.

In line with the statute, which was passed by Congress as part of last year’s Dodd-Frank financial overhaul, securitisations are permitted, including a related “limited amount of interest rate or foreign exchange derivatives”.

Proponents of the exemptions to the Volcker rule say the exemptions are needed, to make sure U.S. financial markets remain vital and are not damaged by the new regulations.

Regulators have not made the final decisions on what will be covered by the Volcker rule, Braithwaite reported:

The rule was named after its champion Paul Volcker, the former Federal Reserve chairman, who pushed for last year’s financial regulatory overhaul to include a crackdown on the “casino” activities of banks. Regulators, led by the Fed, are trying to translate the law into detailed rules.

Repos and securitization – which Yale economist Gary Gorton calls “securitized banking’ – was the combination that fueled the housing bubble and bust. Banks have repoed and securitized for years, but new laws and regulations between 2000 and 2005 made securitized banking lethal between 2007 and 2009.

Here’s how securitized banking worked:

 Typically, mortgage lenders borrowed on the repurchase market, used the money to make home loans, and sold the loans to a separate bank, company or trust. That trust, which also borrowed on the repurchase market, pooled the loans and sold asset-backed securities and asset-backed commercial paper (ABCPaper) backed by the home loans to investors and financial institutions, including investment banks and commercial banks.

Repurchase agreements and asset-backed commercial paper are short-term, often overnight, collateralized loans. In the housing boom, they were often collateralized by home loans or derivatives of the home loan pools.

In 2007 the lenders who were buying the repos and the ABCPaper, led by money market funds, began to lose faith in the collateral and, eventually, in the borrowers. They demanded more collateral, and in 2008 they withdrew from the market, refusing to roll over the repos and the ABCPaper. That run on repos and ABCPaper caused the credit panic of 2007-2009.

In spite of the critical role the repurchase market played in the panic, regulators have not touched repos, the Dodd-Frank Act nearly ignored them, and an industry task force assigned the job of preventing future runs on repos said it could not find a solution.

One reason the repo market is being handled with kid gloves may be its importance to the Federal Reserve as a key instrument of monetary policy.  When the Federal Reserve’s Open Market Committee wants to influence credit markets, the Fed buys and sells securities on the repurchase market with selected brokerage firms.

Editor’s Note: The Wall Street Journal, no doubt stung by the Financlal Times’ September 18 scoop, ran a story September 22 about the proposed Volcker rule, but it never mentioned repos or securitization. Instead, it said the Volcker rule may give banks much more latitude to engage in hedging trades than Dodd-Frank intended. RepoWatch wishes the Wall Street Journal had dug further into the repo and securitization exemption. The finance lawyer who blogs at Economics of Contempt said September 25 that the Wall Street Journal story  was “100% wrong.” Presumably the Wall Street Journal disagrees.


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