As 2014 comes to a close, it’s tempting to try to assess how much systemic risk has been wrung out of the repurchase market by six years of reforms.
A fair summary would be: Much proposed but little imposed.
In fact, there’s still disagreement on what to do.
One way to analyze the progress might be to see how well the reforms mimic three key programs that have stabilized commercial banking since the 1930s: (1) Federal Reserve loans to help troubled but still-solvent banks, (2) FDIC insurance to protect depositors, and (3) regulation to make banks financially stronger.
This method for analyzing progress – comparing repo reform to bank reform – has merit because the underlying problem was the same, both for banks in the decades leading up to the 1930s and for the repurchase market in 2007 to 2009: financial panic and runs on banks.
— In the early 20th century, lenders (depositors) lost faith in the solvency of their borrowers (commercial banks) and suddenly demanded their money back. But the banks didn’t have the money any more. They had re-used it to make loans and investments. This created a panic that threatened to bankrupt the commercial banks and the economy.
— In the early 21st century, lenders (on the repurchase market) lost faith in the solvency of their borrowers (investment banks) and suddenly demanded their money back. But the banks didn’t have the money any more. They had re-used it to make loans and investments. This created a panic that threatened to bankrupt the investment banks and the economy.
As Federal Reserve Governor Daniel Tarullo, the governor with the most responsibility for post-crisis reforms, explained in a November 20 speech about progress that’s being made toward preventing runs:
The financial turbulence of 2008 was largely defined by the dangers of runs–realized, incipient, and feared. Facing deep uncertainty about the condition of counterparties and the value of assets serving as collateral, many funding markets ground to a halt, as investors refused to offer new short-term lending or even to roll over existing repos and similar extensions of credit. In the first instance, at least, this was a liquidity crisis. Its fast-moving dynamic was very different from that of the savings and loan crisis or the Latin American debt crisis of the 1980s. The phenomenon of runs instead recalled a more distant banking crisis–that of the 1930s.
The structure of the repurchase market makes it particularly vulnerable to runs. Here’s how that works.
On the repurchase market, lenders make short-term loans to borrowers. Because these repo loans are only for overnight or for just a few days, the lenders can quickly withdraw in times of trouble, by refusing to renew the old loan or to make a new one. The lender just suddenly demands its money back.
We’re talking big money here. More than $3 trillion is outstanding on the U.S. repurchase market every day, compared to less than $300 billion that typically trades daily on the U.S. stock markets. The $3 trillion flows throughout the financial markets, making its way to investors, corporations, businesses, governments, pension plans, insurance companies, and speculators.
If that flow stops, commerce stops.
Repo lenders are almost any large pool of money, like money market funds, hedge funds, government and corporate treasuries, pension plans, and endowments. Repo borrowers are almost any large participants in the financial markets, but especially investment banks and their broker-dealer operations.
When the repo lenders withdrew in 2007 and 2008, this created a panic that threatened to bankrupt the investment banks, most prominently the Big Five: Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. All five were saved by becoming parts of commercial bank companies except Lehman Brothers which failed.
With the collapse of these financial giants, the potential damage to thousands of their trading partners, and the runs that then hit the broad financial markets, the U.S. economy came close to Armageddon, Federal Reserve Chairman Ben Bernanke told the Financial Crisis Inquiry Commission.
As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression …Out of maybe the 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.
Since then, the Federal Reserve and other regulators have been proposing reforms for commercial banks and for other giant companies whose financial weakness could destabilize the U.S. financial markets. While few of the key reforms have actually been imposed, these financial institutions apparently believe some eventually will be, and they have been adjusting their operations somewhat.
But the Securities and Exchange Commission, which is the regulator for broker-dealers, has done little to reform them or other repo borrowers. For example, a U.S. Treasury Department report this month warned that mortgage real estate investment trusts (mREITs) are becoming big repo borrowers and are increasingly vulnerable to runs.
Following is a discussion of proposed repo reforms, as they relate to the three key fixes that have prevented runs on commercial banks from spreading throughout the banking industry since the 1930s.
(1) Federal Reserve loans to help troubled banks
In normal times the Federal Reserve can only lend to financial institutions that take deposits from the public – commercial banks, savings and loans, savings banks and credit unions – but the Fed can lend to non-banks in an emergency.
In 2008 the Fed saved the investment banks and others by getting money to them in a host of ways, and in the next crisis it clearly will do so again. Dodd-Frank doesn’t allow the Fed to save individual institutions any more (as it did American Insurance Group, for example, by making emergency loans to the insurance company), but it does permit the Fed to provide emergency funding to the financial system, with the Treasury Secretary’s approval. The Fed has shown that it will move heaven and earth to keep credit flowing.
This helps the Fed respond to a crisis, but it doesn’t help the Fed prevent one. Some want to allow broker-dealers to borrow from the Fed at any time, as depository institutions can, because that could keep weakness at one firm from turning into a market-wide panic. But broker-dealers don’t want the expense and bother of commercial-bank-style regulation that would likely come along with such an arrangement.
(The main broker-dealers operating in the U.S. are listed here. A description of the inner workings of broker-dealers, often in affiliation with commercial banks, is here. They play complex roles in the economy, for example as repo borrowers who re-use the repo cash, or as repo lenders who re-use the repo collateral.)
In summary, the Fed can lend into the financial markets only during an emergency, not before.
(2) FDIC insurance to protect depositors
The insurance for repo lenders, who are the “depositors” on the repurchase market, is the collateral that repo borrowers must put up to get a loan. The collateral is usually bonds, stocks and other kinds of securities but it can also be cash, metals or whatever the lender will accept. If the repo borrower can’t repay the loan, the repo lender can sell the collateral.
Obviously, a lender that has to sell collateral to get repaid, possibly into a market where prices for the collateral are falling as everyone unloads, has less certainty of repayment than a bank depositor protected by FDIC insurance, which repays depositors all their cash up to $250,000 and is backed by a taxpayer guarantee.
(FDIC insurance is paid for by banks, but if a crisis is so severe that the FDIC can’t repay all insured depositors, the U.S. taxpayer will step in. In the 2008 crisis, the FDIC was able to cover all costs).
The 2008 crisis was triggered when repo lenders lost faith in the mortgage-related securities that were the collateral, or “insurance,” for many of their repo loans and they suddenly demanded that the borrowers put up more collateral or repay those loans.
Since then, ironically, financial markets have become even more reliant on secured lending, because it seems safer than unsecured. “Collateral is the new cash,” some proclaim. Companies are building systems that will track down collateral no matter where it is, calculate how to use it most profitably, and move it to where it’s most needed, all with lightening speed. The importance of sound collateral to the world’s economies has never been more critical.
Several steps have been taken to strengthen U.S. repo collateral since the crisis, with questionable results. For example, most mortgage securities are now backed by a taxpayer guarantee supplied through Freddie Mac and Fannie Mae. But the Obama Administration and many in Congress want to close these agencies down. In another example, Congress has instructed credit rating agencies to rate bonds and other securities more accurately, which should help repo lenders avoid risky collateral. But a profound conflict of interest in the credit rating business – where credit rating agencies are paid by the securities seller instead of by the securities buyer – makes ratings inherently unreliable.
Other reform ideas include:
Some experts would like to see regulation that requires more collateral be posted for each loan. That’s called requiring a bigger haircut.
Some would like to see the government set up FDIC-type insurance that repo participants would have to buy. Then in a crisis, the FDIC could repay lenders for any losses they took when they had to sell collateral. Knowing the FDIC was there to make lenders whole could keep them from running, advocates reason, just as FDIC insurance has largely kept bank depositors from running for 80 years.
Some would allow only U.S. Treasury or other government agency securities to be used as collateral on the repurchase market, especially during a financial crisis. If that doesn’t provide enough collateral to keep credit flowing, they would have the U.S. Treasury issue more debt.
Some, for example here and here, are calling for rolling back the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act. The Act says mortgage-related securities that a repo borrower has put up as collateral are exempt from the claims of other creditors if the repo borrower goes broke. In other words, when a repo borrower files bankruptcy, its repo lenders can sell mortgage collateral right away, without having to wait for a bankruptcy judge to approve a repayment plan for all creditors. This makes mortgage-secured repos very popular with lenders, and it also invites these lenders to run early, perhaps even drive a borrower into bankruptcy, because the lenders don’t have to worry that a bankruptcy judge might reach back to seize the proceeds of their collateral sale. Prior to 2005, only repos collateralized by U.S. Treasuries and other safe government securities got such special treatment in bankruptcy court.
Some would set up a clearinghouse to buy collateral at a decent price from lenders during a panic or a special bank that would make loans to lenders so they wouldn’t have to sell collateral in a panic.
Some would require that all repurchase transactions be conducted through a clearinghouse, which could monitor collateral quality, value and availability.
Some repo participants object to the above reforms as being too expensive and warn they could make repos uneconomical to transact.
To the extent that The Federal Reserve uses its vast store of securities as collateral to borrow money on the repurchase market, through its new reverse repurchase program, repo lenders to the Fed will in effect be insured because they’re dealing with the safest counterparty in the world. But how many of these transactions the Fed will do is uncertain, in part because they put the Fed in competition with other repo borrowers.
In summary, many insurance ideas have been proposed. Little has been implemented.
Meanwhile, recent cases of collateral fraud show how fragile repo collateral can be. The Illinois Metropolitan Investment Fund said it lost $50 million this year by accepting as collateral U.S. Agriculture Department-guaranteed loans that turned out not to exist. Citigroup Inc. said it’s owed $270 million because the metal it accepted as collateral is in Chinese warehouses seized by the Chinese government.
It’s all reminiscent of Lee Farkas, convicted of bank fraud in 2011 in part because he got repo loans from Colonial Bank in Montgomery, Alabama, using fake collateral. According to business writer Floyd Norris, Farkas said:
It’s very common in our business to, to sell — because it’s all data, there’s really nothing but data — to sell loans that don’t exist. It happens all the time.
(3) Regulation to make banks financially stronger
This is the area where reform is most likely.
U.S. and European bank regulators say they will make banks and selected non-banks meet lots of new requirements. Among them:
— Capital ratios: Institutions will have to finance their operations using more capital – which is their profits and the money they get from selling stock – and less debt, so they’ll have more of their own money at risk.
— Total Loss-Absorbing Capacity: Institutions that regulators deem to be “global systemically important banks” will have to maintain even higher capital ratios, to avoid being Too Big To Fail.
— G-SIB surcharge: The “global systemically important banks” will have even higher capital requirements if they use short-term funding like repos.
–– Liquidity Coverage Ratio: Institutions will have to hold enough high-quality liquid assets, such as bonds or other securities, to meet financial demands during a 30-day crisis, and there will be a surcharge if they’re financing longer-term assets with short-term loans.
— Net Stable Funding Ratio: Institutions will have to have a year’s worth of stable financing, such as retail deposits and funding with maturities of greater than six months, that matches the maturities and other characteristics of its assets and its off-balance-sheet exposures.
— Living wills: Institutions must draw up road maps that show regulators how to close down the company if it’s failing.
— Granular oversight: Regulators have launched several programs to dive deeply into how well institutions will hold up under periods of significant stress.
Meanwhile, the Securities and Exchange Commission is tightening the screws on money market funds, thought to be the largest group of repo lenders. In 2010 the SEC required these funds to shorten the maturities of their investments, so they can get cash fast in an emergency, and to accept only cash or government securities as repo collateral. In 2016 money market funds will have to start making new disclosures, they will have the right to temporarily suspend redemptions or charge redemption fees, and the share price of prime institutional money market funds will no longer hold steady at $1 and instead will fluctuate with the market.
Federal Reserve Governor Tarullo discussed the new regulations in his November 20 speech. He also remarked:
Designing and implementing a policy response in light of the vulnerabilities of short-term wholesale funding markets that were revealed in the 2007-09 crisis is an integral part of post-crisis reform. The key question is how to balance the important role these markets have come to play in funding economic activity with the need to contain the destabilizing risks of runs in these same markets. ….
During normal times, short-term wholesale funding can help to satisfy investor demand for safe and liquid investments, lower funding costs for borrowers, and support the functioning of important markets, including those in which monetary policy is executed. But during periods of stress, runs by providers of short-term wholesale funding and associated asset liquidations can result in large fire-sale externalities and otherwise undermine financial stability. (RepoWatch editor’s note: Short-term wholesale funding is mainly repurchase transactions but can also include other short-term loans like jumbo CDs, brokered deposits, central bank funds, securities loans, commercial paper and asset-backed commercial paper.)
Some market participants warn that these new requirements will make repo too expensive, and as a result investors will have a much harder time buying and selling their holdings, because counterparties won’t be able to get quick cash or securities from the repo market to do the deal.
Already, some say, repo deals are migrating out of regulated institutions, to instead be transacted privately or by lightly regulated traders who do not have to meet the costly new standards.
In summary, most of the new requirements are still being negotiated. They’re scheduled to be phased in over several years. Resistance is unrelenting. With so many moving parts, the final result can not be known.
Editor’s Note: The above discussion is simplified. It does not mention rehypothecation, credit intermediation, special purpose vehicles, shadow banking, monetary policy, reverse repurchase agreements, derivatives, value at risk, credit default swaps, collateralized debt obligations, and so on. Hopefully, it’s therefore easier to understand. Readers will find the technical details in the links. For a further discussion of banking reforms and how they might be applied to repo, see RepoWatch’s Shadow Banking, part 3.