THERE’S REASON TO WORRY WHEN EVERYONE FROM rating agencies to regulators starts talking about a corner of the capital markets that previously enjoyed peaceful obscurity — while the banks that arrange and manage the deals remain tight-lipped.
Such is the case for the U.S. repurchase, or repo, market, where banks and other financial institutions borrow cash from money market and pension funds by pledging securities as collateral. The tensions that led to the notorious repo squeeze of 2008 are resurfacing, experts fear. These include a hunger for yields far above the paltry returns offered by U.S. Treasuries and a growth in the supply of securities that meet this demand — but at higher risk.
In the wake of the Lehman Brothers Holdings collapse of September 2008, funds curtailed lending to banks through repo. They got especially stingy if the banks had put illiquid and hard-to-price assets such as residential-mortgage-based structured products up as collateral, says Bruce Tuckman, director of financial markets research at the Center for Financial Stability, a New York–based think tank.
“At the height of the crisis, people said, ‘I don’t know how much this is worth; don’t come near me with it,’ ” Tuckman recalls. A recent study by credit rating agency Fitch Ratings found that at one point in 2009, repo transactions backed by structured finance fell to zero among the $90 billion worth of deals examined. To avert disaster, the Federal Reserve System had to step in and lend its own cash for shunned collateral. But confidence returned to the repo market, which has stabilized at a lower level than before the credit crunch. Recent Fed figures show $1.7 trillion in contracts outstanding, versus industry estimates of about $2.8 trillion before the crisis.
If the repo crash for structured finance was unusually spectacular, so has been the rebound, prompting fresh questions about the asset class’s suitability. Fitch notes that by August 2011 the share of repo cash lending backed by structured finance had risen to one fifth — the highest since 2007 — among the loans it studied. That would put structured products behind more than $300 billion worth of deals.
Renewed investor confidence in structured finance and money market funds’ search for yield drive this trend, Fitch says. At one end of the risk spectrum lie Treasuries, which offer an annualized repo yield of about 5 basis points. But the Fed estimates that they account for just 34 percent of the repo market. The bulk consists of riskier and less liquid assets offering correspondingly higher returns, with structured finance currently commanding yields as high as 50 basis points when financial markets are jittery.
“Deeply discounted structured-finance repo collateral is relatively less liquid than government securities,” says Robert Grossman, a New York–based analyst in macro credit research at Fitch. “But we’re in a low-interest-rate environment, and repos backed by these securities offer a higher yield.”
Money market funds prefer low-risk and liquid markets; structured products are risky and illiquid. If funds decided to resolve this tension by rejecting them as collateral, their prices could fall rapidly, hitting not only banks but also structured-finance investors who had never even dabbled in the repo market.
One possible solution raised by U.S. government officials is an industry-owned body to prevent such free falls by quickly purchasing securities that have lost favor among repo cash lenders and selling them off when prices stabilize. The CFS’s Tuckman also suggests excluding illiquid and hard-to-price collateral from the safe-harbor rules that protect cash lenders; if a repo counterparty defaults, it can sell collateral immediately, thus avoiding a long bankruptcy process. “The safe-harbor provisions are too broad,” Tuckman says. “You can lend money on pretty bad collateral and resolve your claim before other creditors. That lets people take more risks through the repo market.”
A less radical fix: Cash lenders could show greater prudence. “Money market funds are spending more time analyzing counterparty risks, as well as looking at the level and amount of underlying collateral,” notes Henry Shilling, New York–based senior vice president of the managed investments group at credit rating agency Moody’s Investors Service.
The longer-term answer is for banks to seek new funding streams. In February, Moody’s put 13 financial institutions, including JPMorgan Chase & Co. and Morgan Stanley, under review for potential downgrade, citing “fragile funding conditions.” Moody’s and its peers drew fire in 2008 for giving excessively high ratings to many structured-finance securities whose value tumbled during the credit crunch — including some commonly used in repo.
“Our action partly reflects the lessons of the 2008 crisis, when the repo market was less stable than anticipated,” acknowledges Peter Nerby, senior vice president in banking at Moody’s in New York. “If you rely on shorter-dated repo with lower-quality collateral and other forms of wholesale funding rather than long-term debt or retail deposits, you face a greater risk.” • •
