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Repo: MF Global exposes short-term risks

Risk from a large dealer failure; Window dressing of exposure common

When it became clear that the $6.3 billion (later revealed to be more than $11 billion) sovereign debt position that brought down MF Global was collateralizing a repo trade, increased scrutiny of the short-term funding market seemed inevitable. By treating the exposure as repo-to-maturity the brokerage was able to treat the assets as off-balance-sheet, an idiosyncrasy of the market that can be exploited by banks and brokerage houses when reporting quarterly figures.

"There is this issue of ‘debt masking’ out there," a New York-based banker tells Euromoney. "One way banks can reduce the appearance of leverage is through the repo market. MF Global and Lehman Brothers both engaged in this activity to various degrees by getting the assets off the balance sheet and appearing to have less leverage around quarterly reporting time."

Lehman Brothers was removing the securities put into the repo market frdoom the asset side of its balance sheet and using the borrowed cash to pay some of its debt temporarily, the now notorious Repo 105 trades.

Repo 105

In their recent book, Regulating Wall Street: the Dodd-Frank Act and the new architecture of global finance, Viral Acharya, CV Starr professor of economics at NYU Stern’s department of finance and his colleagues say that in some quarters Lehman’s Repo 105 transactions amounted to as much as $50 billion.

“The idea of the Dodd-Frank Act was to address the too-big-to-fail problem, at least some of which arises from short-term financing and the shadow banking markets. So it is odd that the Dodd-Frank Act leaves out the repo market”

Viral Acharya, NYU Stern
Viral Acharya, CV Starr professor of economics at NYU Stern’s department of finance

"The idea of the Dodd-Frank Act was to address the too-big-to-fail problem, at least some of which arises from short-term financing and the shadow banking markets," Acharya says. "So it is odd that the Dodd-Frank Act leaves out the repo market. It is a concern. What if Bank of America were to go under from exposure to housing markets and a double-dip recession? With 10% to 20% of overall assets held by the US financial sector being with Bank of America, that would result in the several money market funds that provided short-term financing in exchange for Bank of America’s mortgage-backed securities (MBS) assets all trying to sell into an illiquid market. One of those funds could easily break the buck as a result. In addition, the lack of clarity around which money market funds are exposed and to what extent could create a further contagious run on other funds and we could be back to September 2008." One way to ensure that banks and dealers are not using repo markets to disguise their exposure is to force them to report quarterly averages as well as end-of-quarter figures.

"When analysts see a discrepancy between quarterly averages and end-of-period figures then they would have a better idea whether some window-dressing is going on," says an observer. The SEC has made the proposal to introduce average quarterly reporting but it has not seen a final ruling.

The repo market is just half the $2.8 trillion size it was in 2008. There have been several efforts by regulators to encourage banks to term out their funding (such as the recent tri-party repo market reform) but, as Joe Abate, money markets strategist at Barclays Capital explains, the flightiness of repo cash lenders that simply pull funding when markets wobble remains a concern. He adds that dealers tapping the deposit markets for funding is shifting the liability mix of banks away from wholesale funding.

The academics at NYU Stern have proposed a repo clearing house or repo resolution authority that would step in and allow for an orderly liquidation of collateral backing repo contracts should there be a shock to an asset class such as mortgages. "The problem is that a repo is legally not like a secured borrowing agreement – it is a sale and repurchase agreement – which means that the financing institution can just seize and sell the assets on. That creates risk in less-liquid asset classes such as MBS if repo financiers all try at once to sell the assets. So why not let the liquidation occur in an orderly fashion through a repo clearing house? Such infrastructure, as is currently being planned for several large derivatives markets, also needs to be put in place for repo markets."

A further concern in the repo market is that neither the bank nor the money market funds have to hold capital against the liquidity risk of the asset that is being financed. "When a bank repos, it gets a discounted capital requirement on the MBS as it removes the asset from its banking book and moves it to its trading book," says Acharya. "The money market fund considers it a one-day loan. Thus, there is no party that is taking claim of the asset if it cannot be rolled over or liquidated, and in turn, no party is holding capital against it or being asked to do so."

Not surprisingly industry participants defend the market.

Rob Toomey, managing director and associate general counsel at Sifma, says it "is one of the safest sources for short-term funding", and that changes such as the tri-party repo reforms have been a step forward in making the market resilient. The tri-party repo infrastructure taskforce sponsored by the Federal Reserve Bank of New York implemented several changes this year to make the market more stable, such as the elimination of the wholesale "unwind" of repos.

Acharya says that other changes being discussed are helpful but not the whole picture. "People have focused on the micro issues surrounding repo markets such as counterparty defaults during the day, which are important, but the macro risks – if a large dealer or a few of them were to fail in a short period of time – are more pressing from the system’s stability standpoint," he says. "Regulation on haircuts, for example, that would prevent them being close to 0% in good markets and up to 50% in bad markets would dampen activity. Reducing the size of the repo market – if it helps contain to reasonable levels the short-term leverage built on systemic assets such as mortgages – would not necessarily be a bad thing." 

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