Fed Considers Repo Reform

Pundits examining the failures of the financial system that precipitated the Credit Crisis of 2008 often point to two areas of the market outside the traditional realm of banking: money market funds and repo markets. We blogged previously about the reforms to money market funds, and now the Federal Reserve has begun to push forward again on the issue of repo markets.  

In a traditional repo agreement, one party sells an asset to another with a guarantee that they will repurchase it later at a higher price. The party buying the asset has essentially issued a collateralized loan, while the party selling the asset has borrowed (the difference between the sale price and the repurchase price is the interest rate charged on the loan). Lending is usually not extended for the full value of the security pledged – different haircut amounts (discounts from market value) are extended based on the type of security. During the Credit Crisis, when the quality of all assets save Treasuries were called into question, counterparties (repo buyers) were unwilling to run the risk of being left with the pledged asset, whose market value had likely declined dramatically, and refused to roll forward existing repos and demanded that existing obligations be settled. As a result, short-term credit for banking institutions all but evaporated, kickstarting the general global credit crunch. This 'run on repo' was similar to the 'run on the fund' experienced by money market funds and reminiscent of classic bank runs of the past.

Banks are involved in repo markets as part of a 'tri-party' system, with JP Morgan and BNY Mellon being the two largest players in the $1.6 trillion market. The bank provides custodian services and stands between the two counterparties to the repo transaction. Back in April, JP Morgan issued a statement indicating that it had enacted changes suggested by the Fed to reduce credit risk in the market, moving to rolling settlement, simultaneous exchange of cash and collateral, and a secured committed clearing facility. According to the most recent data made available by the Federal Reserve Bank of New York, agency MBS and Treasuries make up the majority (66%) of collateral posted today (see table below).

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Median haircuts on Agency MBS and Treasuries were about 2%, while assets like private-label mortgages carried average haircuts of 8%, with a range of 3-15%. The marketplace, even in recovery, still places a high value on certain collateral.

The issue of changing repo market regulation was raised at an earlier Federal Reserve conference in October of last year, and has remained in the background since. On Wednesday of last week, Federal Reserve Bank of Boston President Eric Rosengren pushed the dialogue further forward. While he noted the steps that banks had taken to insulate themselves from the effects of repo market turmoil, he voiced concern over the high level of reliance on repo markets for most broker-dealers. Mr. Rosengren suggested a number of new proposals, ranging from limiting the use of repo funds to finance long-term assets all the way to allowing broker-dealers to access the Fed's discount window directly. He also suggested limiting the ability of money market funds to make repo loans against collateral that does not meet their strict investment requirements.

The Federal Reserve Bank of Boston produced data illustrating the need for reform in these areas visually - for example, the chart below shows the high degree of money market fund activity in the repo space:

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Perhaps the most compelling information that Mr. Rosengren presented concerned the reliance of broker-dealers on repo transactions. We begin with the chart below showing the general decline in checkable, time and savings deposits as a percentage of credit market instruments. These would have been traditional sources of funding for banking entities. The large scale decline over the modern era corresponds directly to the rise of other funding sources (like repo markets) that developed during this time.

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During the same time period, broker-dealers in particular dramatically increased their exposure to repo agreements, especially compared to other types of institutions, becoming heavily reliant on them as a source of funding (see chart below).

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This dramatic increase left about half of their capital structure made up by repos, a trend which still persists today (see chart below).

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This degree of exposure is what concerns the Federal Reserve, which has begun to propose new rules in order to curtail it. Regulators have been active elsewhere in the repo marketspace – we blogged last week about large-scale fines handed down by FINRA in the first-half of 2014. One of those, against Deutsche Bank for $6.5 million, was related to repo practices executed through its enhanced lending program designed to serve its hedge fund clients.

Banks have been pulling back from repo markets for the duration of 2014, perhaps as a result of increased concern over regulatory exposure for activity in this area. Since January, Goldman Sachs has cut repo lending by $42 billion, Barclays by $25 billion, Bank of America by $11.4 billion, and Citigroup by $8 billion. JP Morgan, because of its large role in the tri-party market, has maintained the same level of repo lending.

The continued reliance of many financial market participants on repo transactions for funding or investment purposes validates the Fed's concern over regulation in this area. However, changes to the structure of this enormous funding market will have a large impact on its primary users: namely, hedge funds and broker-dealers relying on repo transactions for funding, and money market funds relying on repo transactions as investments. Proposed changes must weigh the balance between keeping funds flowing in bad times and choking them off in good times through excess oversight.