A series of conferences and reports in the second half of 2014 show that the economists who best understand the repo phenomenon are still worried about it and working to stabilize it.
This is welcome news, after months of concern over collateral shortage, collateral quality, repo straying into the shadows, fails, frankenstein securitizations, equity collateral, and government warnings that we still don’t have reliable repo data.
Since so few people understand the role of short-term debt in the financial crisis – meaning mainly repurchase agreements, but also securities lending and asset-backed commercial paper — and since so little has been done to restrict such borrowing in the future, it’s reassuring that experts who do understand what happened in 2007-2009 are still on the case.
Monthly, for six months, they have sounded a drumbeat of concern.
July: In New Haven, Conn., Andrew Metrick and Gary Gorton, the Yale professors who first figured out the critical role that the repurchase market played in the financial crisis and wrote scholarly papers to explain it to others, spearheaded the school’s first annual Systemic Risk Institute.
Mid-level regulators from around the world, who might be on the front line during the next financial crisis, were invited to New Haven to study past crises and debate resolutions.
The university described the two-week summer school as a “boot camp for a dozen rising regulators who may be in positions of influence if another crisis hits.” The Wall Street Journal described it as “the first-ever regulatory boot camp.”
It’s hard to imagine a more important endeavor.
August: In New York the Federal Reserve Banks of New York and Boston held a “Workshop on the Risks of Wholesale Funding.” The workshop focused on short-term wholesale funding, which is mainly repurchase transactions but can also include other short-term loans like asset-backed commercial paper, securities loans, jumbo CDs, brokered deposits, central bank funds, and commercial paper.
According to the workshop agenda, this conference dealt with the thorniest of repo issues, including rehypothecation, where securities can be reused as collateral several times in a daisy chain of loans, and also including the safe harbor treatment repo loans get when a borrower files bankruptcy. Under this safe harbor, repo lenders can get paid off right away while other creditors have to fight over what’s left.
In his keynote remarks, Eric S. Rosengren, president of the Federal Reserve Bank of Boston, said regulators have not done enough to corral the repurchase market, and he called for a repo overhaul, including requiring financial companies that repo to have a larger share of their own money, and their owner’s money, at risk.
He focused particularly on broker-dealers, the biggest group of repo borrowers. They are regulated by the Securities and Exchange Commission and have not faced much reform since the crisis. He concluded, “… a comprehensive re-evaluation of broker-dealer regulation is overdue.”
(The key broker-dealers in the U.S. are listed here. A description of the inner workings of broker-dealers, often in affiliation with commercial banks, and the complex role they play in the economy is here.)
At the Fed’s workshop, Metrick and Gorton presented their most recent study, “The Flight from Maturity,” in which they detail how the crisis began in the repurchase market on July 23, 2007, and stealthily disrupted financial markets until the eruption with Lehman Brothers’ failure in September 2008.
Why did the failure of Lehman Brothers make the financial crisis dramatically worse? Our answer is that the financial crisis was a process of a build-up of risk during the crisis prior to the Lehman failure. During the crisis market participants tried to preserve an option to withdraw or exit by shortening maturities – the “flight from maturity.” … With increasingly short maturities, lenders created the possibility of fast exit. The failure of Lehman Brothers was the tipping point of this build-up of systemic fragility.
“The Flight from Maturity” and most of the other papers presented at the workshop are posted online and worth study. As long as these issues are being discussed by top economists and regulators, perhaps solutions can be found.
September: In Washington, D.C., the savviest Federal Reserve governor on reforms, Daniel K. Tarullo, gave Congress an update on re-regulation of the financial markets since the financial crisis. A key topic was “short-term wholesale funding.” Progress has been made, he said, but there’s much more to do.
… we believe that more needs to be done to guard against short-term wholesale funding risks. While the total amount of short-term wholesale funding is lower today than immediately before the crisis, volumes are still large relative to the size of the financial system. Furthermore, some of the factors that account for the reduction in short-term wholesale funding volumes, such as the unusually flat yield curve environment and lingering risk aversion from the crisis, are likely to prove transitory.
October: The Office of Financial Research, created by the Dodd-Frank Act to produce the data regulators need to carry out their new mandates, announced a project early next year that will “fill a key gap in our ability to measure financial activity.” Director Richard Berner explained in his blog:
The project focuses on repurchase agreements, or repos, which are a major source of short-term funding for the financial system. A repo is essentially a collateralized loan — one party sells a security to another party with an agreement to repurchase it later at an agreed price.
Repos are instrumental in providing funding and liquidity — the lubrication that helps to keep the global financial system operating. The U.S. repo market efficiently provides more than $3 trillion in funding every day.
However, vulnerabilities in repo markets can also contribute to risks to financial stability. The concern arises because of the potential for shocks to the financial system during times of market turbulence to cause repo liquidity to dry up.
The repo market is divided into three parts: (1) the triparty repo market, where transactions are centrally settled by two large clearing banks; (2) the general collateral financing, or GCF, market, where interdealer repo transactions are centrally cleared; and (3) the bilateral market, where repo transactions are conducted privately between two firms.
Information and data on the triparty and GCF markets are published regularly, but information about bilateral repos is scant.
The Office of Financial Research said its project will focus on bilateral repo.
November: Fed governor Tarullo was back in November, this time as a keynote speaker at the Clearing House’s annual conference in New York, where he surveyed the progress made in reforming the short-term lending markets for the nation’s “leading regulators, academics, industry executives and legal and regulatory professionals” who attended the conference.
In spite of the critical need for reforms, and some important progress, more needs to be done, he said.
Of particular concern, Tarullo said, is the possibility that the tougher regulations gradually being implemented at regulated financial institutions like banks will drive short-term borrowing and lending out to firms that are less regulated, like hedge funds, mutual funds, mortgage REITs, or exchange traded funds, where risks might grow unnoticed.
December: Finally, this month the Office of Financial Research released its 2014 Annual Report, which analyzes potential threats to U.S. financial stability and reports on key research findings. It summarizes:
... several threats to financial stability have risen over the past year. This report highlights three specific risks. First, we see material evidence of excessive risk-taking during the extended period of low interest rates and low volatility. Second, markets have become more brittle because liquidity may be less available in a downturn and the risk of asset fire sales and runs in short-term wholesale funding markets remains unresolved. Third, we are concerned that financial activity is migrating toward areas of the financial system where threats are more difficult to assess because information is not available, and that activity may be consequential. Gaps in analysis, data, and policy also persist, despite progress in narrowing them. If left unaddressed, these threats could adversely affect financial stability.
Regarding the short-term wholesale funding concerns, the report reiterates the Office’s project to collect and analyze bilateral repo data, and it says:
The repo market, the largest short-term funding market, has undergone substantial change in recent years. However, it still remains susceptible to asset fire sales and runs when a borrower cannot roll over or renew short-term funding backed by collateral.
Borrowers in the repo market obtain funding from repo dealers by posting collateral; repo dealers, in turn, often borrow cash from cash-rich lenders. The Federal Reserve, U.S.-based foreign banks, U.S. banks and broker-dealers, and mortgage real estate investment trusts (mREITs) are significant participants in repo markets. Repo markets are vulnerable to runs for several reasons. Repo contracts tend to be short-term. In a market disruption, firms relying on short-term repos could quickly lose access to their funding sources when existing contracts expire and new ones become hard to obtain.
Repo contracts allow borrowers to boost returns by combining leverage with maturity mismatches, which contributes to contagion and fire sale risk. If a market shock leads to concerns about risky counterparties, a repo lender may demand higher margins or terminate the counterparty exposure altogether. The demand for higher margins could force a highly leveraged counterparty to sell some of its assets to meet the new requirements, leading to fire sales. The downward spiral could accelerate if many firms sell assets simultaneously.
The 133-page report includes a detailed discussion of policies to address issues in the wholesale funding markets. See Chapter 3.
Nothing like these reports by the Office of Financial Research existed in the years leading up to 2008, when financial risk was rising unseen and was not understood when it did appear. This research, which is public information available to regulators, the press and the financial markets, could become the bedrock for effective reform.
As seen above, the six-month public drumbeat of concern reveals a determination by the nation’s leading financial minds to press on in their efforts to re-position the repurchase market so it can help keep financial markets fluid but stable.
That said, it’s sobering to be six years beyond the crisis and still be trying to solve its core problem.