Why Backstopping Repo is a Bad Idea

The normally sound Gillian Tett of the Financial Times endorses an idea that is both dangerous and unnecessary, namely, government backstopping of the system of short-term collateralized lending called repo, for “sale with agreement to repurchase.” The problem with her analysis is that her proposal treats symptoms rather than the underlying ailment. It would amount to yet another sop to already heavily subsidized big dealer firms.

The argument, basically, is that the repo system posed and therefore continues to pose systemic risk, ergo a backstop makes sense. As her article puts it:

….the repo market was central to the dramas of 2008. One of the main reasons why entities such as Lehman Brothers collapsed, after all, was that investors fled from repo deals, because they became frightened about counterparty risk. They also feared that the collateral backing these deals was losing value, particularly in relation to mortgage bonds, which represented 37 per cent of collateral.

Yves here. This is the nut of where the argument starts to go off the tracks. It makes counterparty risk the central issue, and the quality of collateral a related issue. But the real problem is that the only securities that were once considered to be suitable were those of the very highest quality, namely Treasuries. The real problem is in widening the market beyond that. If you have absolutely impeccable collateral, you don’t care if your counterparty goes belly up if you aren’t at risk of losses on the assets you hold. As we noted in ECONNED:

Repos have been around for a very long time. But even in the mid-1980s, the repo market consisted solely of Treasury securities, which are safe and highly liquid. Repos only began to become dangerous when, in response to increased demand for paper that could be repoed, more and more dodgy paper became widely accepted as collateral for repos.

Some have argued that the parabolic increase in demand for repos was due in large measure to borrowing by hedge funds. Indeed, Alan Greenspan reportedly used repos as a proxy for the leverage used by hedge funds. Others believe that the greater need for repos resulted from the growth in derivatives. But since hedge funds are also significant derivatives counterparties, the two uses are related.

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts. Hedge funds must typically put up an amount equal to the current market value of the contract, while large dealers generally have to post collateral only above a threshold level. Contracts
may also call for extra collateral to be provided if specified events occur, like a downgrade to their own ratings. (Recall that it was ratings downgrades that led AIG to have to post collateral, which was the proximate cause of its bailout.) Cash is the most important form of collateral.18 Repos can be used
to raise cash. Many counterparties also allow securities eligible for repo to serve as collateral.

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral. The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.” And they did, with that collateral including complex securitized products that banks were obligingly creating.

So the real problem is the use of low quality collateral. And in particular, one of the big proximate causes of the crisis was the use of AAA rated ABS CDOs as collateral. They were subject to only 2%-4% haircuts which by August 2008 rose to 95%. The paper was viewed as worthless, which turned out to be correct.

So why would we possibly WANT a system that might down the road encourage the pledging of less than stellar instruments as repo? We had a massive blowup in the crisis, when it was not a sure bet that banks would be rescued from their recklessness. Unfortunately, Basel III has done nothing to dethrone the role of ratings agencies or risk weightings in determining regulatory capital, so the same incentives to devise paper that gets high ratings but may house hidden risks remains intact.

So we need to go back and look hard at why the need for repo has risen since 2001, and how much is related to legitimate activity. The fact that it grew much more rapidly than the economy overall suggests not. Unless we are certain the post 2001 growth in repo (which is what led it to extend beyond what could be satisfied via Treasuries) supported socially valuable activities, a government backstop is not warranted. Instead, official efforts should proceed along another track, of trying to shrink the repo market (as we’ve recommended for a market that has contributed to the growth of repo, credit default swaps).

Ironically, Tett points out that the current hubs in the repo system (they are now tri-party repos, precisely because a lot of players want a solid party in the middle of these trades to reduce counterparty risk) would fight a change in the current system because they profit from it. But since they are clearly backstopped (no one is going to let a big clearing bank like JP Morgan or Bank of New York fail), in the US we effectively have a backstopped repo system, even though no one in authority will ‘fess up to that (note Tett’s concerns extend to the UK and Europe):

But it seems most unlikely to happen anytime soon…One reason is that JPMorgan and BNY have a vested interest in maintaining the status quo, since it gives them enormous informational power. The other problem is that there is little political appetite right now in the US or Europe for any more upfront, explicit state guarantees to the financial sphere. Unless a repo resolution mechanism is backstopped by, say, a central bank, it is unlikely to be credible. Little wonder, then, that silence rules. Right now it is easier for everyone to keep crossing their fingers – and pray that JPMorgan and BNY remain bulletproof for years to come.

Of course, my suggestion is even more certain not to be implemented, since any effort to intervene in the markets to restrict socially unproductive activity lead to howls that it will reduce credit growth and hence hurt the economy. But our efforts NOT to restrain banks leads to a tremendous tax on all of us.

Andrew Haldane of the Bank of England in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:

….these losses are multiples of the static costs, lying anywhere between one and
five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting. That means we need to keep our eye on the ball and push for remedies that restrict the scope of their activities and the amount of safety nets.