“TARP Fee” to Restrict Repos, A Big Source of Funding for Dealers

Early on in the TARP fee discussion, we mentioned in passing that it would probably have an impact on repo financing.

Repo means “sale with agreement to repurchase.” It’s a pawn-broker-like procedure that involves securities. The borrower gets to park his holdings with another party, with an agreement to buy them back at a specified future date, with interest, and gets the market value of the instrument back, less a haircut. There are more bells and whistles, but that’s the basic idea.

For the borrower, it’s an ready source of cash, or securities eligible for repo can be used as collateral. For the lender, it’s an alternative to deposits (in theory, a party with cash, like money market fund, is better secured holding a short-term secured loan than having large, unguaranteed deposits in a bank).

Once upon a time, only Treasuries were accepted for repos. But as the derivatives market exploded, so to did demand for collateral (the party who might need to make a payment has to post collateral to prove he can make good on his exposure, with the amount of collateral adjusted if the value of his obligation changes by more than a certain amount). So other types of AAA paper began to be used for repos. As dealers learned to their sorrow, not all AAA paper was created equal. Our favorite nemesis, 2006 and 2007 vintage AAA-rated asset backed securities CDOs, turned out to be pretty close to worthless.

So as expected, the TARP fee will make repo finance more expensive (in this low-yield environment, uneconomic). The financiers must have their leverage, so they are howling.

Now getting the big broker dealers to operate with less leverage is a good idea. This TARP fee could be viewed a back-door measure; raising equity requirements for broker-dealers would achieve a similar result. But the banksters are addicted to cheap leverage, and will fight this restriction tooth and nail.

But the odd bit here is that Team Obama appears not to have considered the impact on the repo market. If so, this is an astonishing oversight. And if the Administration decides to exclude repos, which for big broker-dealers prior to the crisis, was often 50% of their borrowings, pray tell what was the point of taxing non-deposit liabilities in the first place?

From the Financial Times:

The Obama administration’s proposed bank levy is threatening the $3,800bn repurchase market…

The potential impact of the $90bn, 10-year levy on the repo market could also complicate Federal Reserve efforts to drain the huge amounts of liquidity it injected into the financial system during the crisis…

Wall Street executives say the proposed levy, which would charge banks a 15 basis point fee on their liabilities minus insured deposits, will prompt them to reduce repo exposure to cut short-term liabilities.

They say the profit they make on repo contracts – about five basis points – would be wiped out by the levy, making repo transactions loss making…

Brad Hintz, an analyst at Bernstein Research, estimated in a recent note to clients that banks could reduce their levy’s bill by about 10 per cent if they scaled back their involvement in the repo market.

But other analysts say a reduction in banks’ involvement in the repo market could be consistent with the levy’s aim of reducing financial groups’ reliance on short-term funding.

A reduction in repo activity could create problems for the US Treasury, which uses the market as an important conduit to sell bonds used to fund its deficit.

“Most of the repo market is associated with Treasury financing and this will make the market function less efficiently,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

The Fed has also tested “reverse repos” – selling assets such as Treasuries to bankers for cash, with an agreement to buy them back later at a slightly higher price – as part of its exit strategy from the stimulus provided during the crisis.

Yves here. Can this gang shoot straight? Or is this yet another “appease the peasants” announcement that was planned from the get-go to be neutered later?