Repos, or repurchase agreements, are a key source of short-term financing for Wall Street banks and other financial institutions, and they are under scrutiny once again for being fraught with risk.
A Fitch Ratings report last week found a significant weak point in repo markets, a part of the “shadow banking” system that finances trillions of dollars in banks’ trading activities.
The repo market is “an important utility in the financial system and promotes liquidity,” says Martin Hansen, senior director of macro credit research at Fitch Ratings. The problem with the repo market currently, though, is the quality of the collateral Wall Street banks and other financial institutions are using to borrow this short-term cash, says Fitch.
In general, repos are used to buy and sell groups of securities, traditionally Treasury bonds and other government agency instruments, in short-term transactions, usually overnight. The securities are put up as collateral by a borrower, typically a Wall Street bank, and in exchange the borrower receives cash from counterparties that charge interest.
But instead of using Treasuries and other government-backed instruments, banks are funding repo borrowing with structured-finance securities — less liquid, more volatile assets. In a stressed market, that could create significant liquidity risks for both repo borrowers (the banks) and the underlying assets, says Fitch. If repo lenders like money-market funds — themselves highly subject to market stresses — suddenly refuse to finance this riskier collateral, it would result in a liquidity shortage for borrowing banks. The banks could then be forced to dump the securities in a “fire sale” that would drive down prices or even make the securities unsellable.
“Before the U.S. credit crisis, there was relatively strong activity in structured finance, and then during the financial crisis that activity virtually disappeared,” Hansen says. “As structured finance lost acceptability as collateral, there where sharp price declines.”
“Some [Wall Street] dealers are very dependent on short-term repo funding and are heavily exposed to rollover risk,” said a July report form the Financial Stability Oversight Council, a group of regulators charged with ensuring the stability of the U.S. financial system. “Of particular concern is the use of short-term borrowing to finance less-liquid collateral, such as asset-backed securities or corporate bonds.”
While Treasury and agency securities still fuel a majority of repo lending, about 35% of the repo market was financed by riskier securities as of February 2012, according to Fitch. About three-quarters of the structured finance, or asset-backed, securities financed were legacy subprime and Alt-A home loans, Fitch says. Moreover, much of the ABS collateral was in small tranches, which are difficult for investors to research and price, compounding liquidity risk.
Included in the category of riskier collateral used by repo borrowers are corporate bonds and equities from more than 1,500 issuers, says Fitch. Most of those securities are from blue-chip names, but a few are from issuers “that have experienced severe credit distress in recent years,” says Fitch, noting it found securities from AMBAC, Lehman Brothers, and Sino Forest among the collateral borrowed against in the repo markets.
Less liquid securities from smaller companies and issuances from a number of tech firms — Verisign, Micron Technology, and Netapp among them — were also in the mix. If Wall Street couldn’t borrow on these bonds and equities in a stressed market, they would most likely have to sell them at a discount, possibly a deep one.
Wall Street uses repo funding as a relatively cheap source of leverage to finance trading activities: their own portfolios or securities they are holding on behalf of clients. The lenders are frequently money-market funds. Money-market funds are willing to lend against structured finance collateral because they earn higher returns from the loans — 72 basis points at the end of February, for example, compared with 18 basis points for collateral consisting of Treasury and government agency securities, says Fitch.
Money-market funds are taking on greater risk by lending against structured finance instruments, of course, and indeed could be stuck with the securities if a bank didn’t pay back the cash it borrowed.
Banks Credit Suisse, Royal Bank of Scotland, Bank of America Merrill Lynch, Citibank, and Barclays are among the large repo borrowers that most often use structured finance securities as collateral for these short-term cash loans, Fitch says.
One positive trend in the market is that repo lenders are becoming more conservative, Fitch says. They are demanding larger haircuts on structured finance repos, meaning they are requiring a larger amount of collateral above the loan amount to protect against adverse moves in the price of the collateral.
From September 2011 to February 2012, the time period of Fitch’s study, haircuts on structured finance repos increased to 7.6% from 5%. That trend could begin to discourage borrowers from using the repo market to fund risky structured finance portfolios.
A hearing by the Senate subcommittee on Securities, Insurance, and Investment last week explored the need to improve risk management and collateral practices in repo markets. Committee members also tried to get to the bottom of which banking regulator is responsible for spearheading reforms, but government staffers testifying couldn’t answer the question definitively.