Friday, December 30, 2011

Understanding Repos, Part 2

In the US, repurchase agreements or "repos" were used as early as 1917 when war time taxes made older forms of lending less attractive.  At first repos were used only by the Federal Reserve to lend to other banks, but the practice soon spread to other market participants.  The use of repos expanded in the 1920s, fell off through the Great Depression and WWII, then expanded again in the 1950s, enjoying particularly rapid growth in the 1970s and 80s due in large part to computer technology.  Although classic repos are credit-risk mitigated instruments, there are residual credit risks.  Though essentially a collateralized transaction, the repo seller (borrower) may default by failing to repurchase the securities at the maturity date.  The buyer (the lender or investor) then is stuck with the security, and has to liquidate it in order to recover the cash lent. The security, however, may have lost value in the mean time due to market movements.  To mitigate this risk, repos often are over-collateralized as well as being subject to daily mark-to-market margining (ie. if the collateral decreases in value, a margin call is triggered demanding the borrower post more securities).  Conversely, if the value of the security rises there is a credit risk for the seller (borrower) in that the creditor may not sell them back.  If this is considered to be a risk at the outset, the borrower may negotiate a repo which is under-collateralized.  Credit risk associated with a repo is thus subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc.  If a party involved in a repo transaction does not have specific securities at the end of a repo contract, this may cause a cascading string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument.  In 2008, attention was drawn to a form of repo known as "repo 105" following the Lehman Brothers collapse, as it was alleged that repo 105s had been used as an accounting trick to hide Lehman's worsening financial health.  Another controversial form of repurchase order is the "internal repo".  In 2011 it has been speculated, though not proven, that internal repos used to finance risky trades in sovereign European bonds may have been the mechanism by which MF Global lost client funds prior to its bankruptcy in October 2011.  Previous to that, concerns arose among bankers and the financial press that if the 2011 U.S. debt ceiling crisis led to a default it could cause considerable disruption to the repo market. This is because U.S. Treasury bonds are the most commonly used collateral within the U.S. repo market, and a default would downgrade the value of Treasuries - resulting in repo borrowers having to post far more collateral.  The U.S. Federal Reserve and the European Repo Council both try to estimate the size of their respective repo markets.  At the end of 2004, the U.S. repo market reached $5 trillion.  The European repo market reached €6.4 trillion by the end of 2006.  Especially in the US and to a lesser degree in Europe, the repo market contracted in 2008 as a result of the financial crisis.  But by mid 2010 the market had largely recovered and at least in Europe had grown to exceed its pre-crisis peak.  Other countries including Chile, India, Japan, Mexico, Hungary, Russia, China, and Taiwan, have their own repo markets, and no global survey or report has been compiled. (Wikipedia)