TO PUT IT MILDLY, THE EURO ZONE DEBT CRISIS HAS fueled mistrust of the banking system. Worried about banks’ heavy exposure to high-risk sovereign bonds, other financial institutions fret over lending them cash. As a result, unsecured borrowing by European banks has plunged in favor of secured funding. The repurchase agreements market plays a big role in these collateral-based deals. “In the second half of last year, there was a long period of next to no unsecured issuance,” says Colin Fleury, head of asset-backed securities investment at Henderson Global Investors in London. “So banks had to look to other sources of funding.”
This problem has persisted because unsecured financing still costs more than it did before the sovereign crisis began. In mid-January, for example, credit default swaps were pricing U.K. banks’ senior unsecured five-year debt at 235 basis points above gilts, compared with less than 150 basis points in early 2011.
But the market remains open for repo trades, whereby banks borrow money by putting up securities as a guarantee. Executives at the big custodial banks, which act as agents for institutions that want to raise cash through securities lending, say European repo activity has stayed brisk throughout the crisis. “The unsecured market is increasingly disappearing,” notes Staffan Ahlner, London-based managing director of collateral management for Europe, the Middle East and Africa at Bank of New York Mellon Corp., which has $26 trillion in assets under custody. “The repo market has benefited because collateralized transactions have become more and more important.”
The value of outstanding repo contracts in Europe was €6.2 trillion ($7.9 trillion) in early December and up 3 percent year-over-year, according to the International Capital Market Association’s European Repo Council. By contrast, senior unsecured debt issuance by European financial institutions slumped to $92 billion in the second half of 2011, Dealogic reports — about one third of the corresponding figure for 2010.
When it comes to unsecured funding, lenders that want their money back rely dangerously on counterparties’ creditworthiness. But institutions lending on the repo market have two lines of defense, says Nicholas Bonn, global head of securities finance at State Street Corp. in Boston. “The first line is ensuring you only make that repo trade with a good, stable investment bank,” explains Bonn, whose firm has $22 trillion in custody. “But since the collapse of Lehman [Brothers], everybody realizes large investment banks can default, so the second line of defense is the collateral they give you.”
Bonn and other repo specialists can attest to cash lenders’ greater fussiness about collateral in recent years. If an asset is relatively risky, lenders will probably demand extra helpings of it for every million euros they provide to the bank. They’re also choosier about individual assets in sectors such as mortgage-backed securities. Theoretically, this should leave the market stronger than in 2008, when spooked lenders suddenly canceled many repo deals with Lehman and other troubled cash borrowers.
A recent innovation that could make financing more stable is the extendable repo, which has gained popularity over the past year. Thirty-day extendables are common: The contract may keep getting renewed, but either side can end it with 30 days’ notice. “Extendable repos are on a strong upward trend,” says John Rivett, London-based global head of collateral management at J.P. Morgan Worldwide Securities Services, a custodian with $16.3 trillion in assets. “The cash borrowers want to have some certainty of the funding they’re getting. An extendable repo is a great way of doing that.”
The 30-day extendable may not be as safe as it first appears, however. What if a bank starts depending on 30-day extendable repos for a big chunk of its funding and then finds them all canceled during one day of heightened market tension? After a month it will face a serious funding squeeze.
Repo experts say cash borrowers can soften the blow by making extendable trades of varying maturity, thus allowing a steady drop in available funds. But the best way for banks to secure stable funding through repos, in good times and bad, is to be flexible about collateral.
Last month Standard & Poor’s downgraded the debt of Italy and eight other euro zone countries. State Street’s Bonn says such events push lenders to tread more carefully rather than abandon repo deals altogether. He gives the example of a bank offering Italian bonds — which S&P knocked down to a few notches above junk status — in return for cash. “I can decide not to do that trade, or I can call the investment bank and say, ‘Yesterday I took Italian bonds worth 105 percent of the cash I gave you. Today I’m going to ask for 107 percent.’” Banks are often happy to make the concession, Bonn says.
So far, at least, that willingness to bend has stopped cash lenders from fleeing the repo market. • •
