Page 4 of 5 THE FOLLY OF INTERVENTION, Part 2 No easy exit for nationalization By Henry C K Liu
Repo contracts allow traders to sell Treasuries without owning them in the
first place, while owners of government debt can fund their portfolios by
lending Treasuries. A zero short-term rate reduces the financial incentive to
lending securities. The reduction in liquidity in the $5.8 trillion Treasury
market is coming at a time when financial market conditions have become
strained. The problems also come as the US Treasury prepares to issue a massive
amount of new government bonds for the current financial year to fund expected
fiscal deficits. President Barack Obama has warned that the US deficit will top
$1 trillion in 2009.
The point is being reached where structural damage caused by near zero interest
rates outweighs any benefit from monetary policy easing through interest rate
cuts. In a financial environment
where the Treasury faces an additional net financing need of over $1.8
trillion, low trading volume caused by near zero short-term rates is a major
problem.
Problems in the repo market will impair general trading across the entire
Treasury market. A rise in "failed" trades, where a borrowed security is not
returned in time, becomes a drain on balance sheets of dealers. Near zero
interest rates are also hampering the ability of dealers to finance positions
by matching offsetting trades. The zero interest rate environment is
effectively eliminating the dealer matched-book business and crippling dealer
intermediation in the repo market.
The scarcity of Treasuries for repos means that buying for repoing will also
lead Treasury prices to rise and yields to plummet. Since Treasury bill prices
are used as the input into other pricing models (most notably the Black-Scholes
option pricing model), the distortions in the Treasure market have the
potential to feed into other markets.
Surging demand for US Treasuries is causing failures to deliver or receive
government debt to climb to the highest level in almost four years in the $6.3
trillion daily market for borrowing and lending. Failures, an indication of
scarcity, surged to $1.795 trillion in the week ended March 5, 2008, the
highest since May 2004, and up from $374 billion the prior week. They have
averaged $493.4 billion a week in 2009, compared with $359.6 billion over the
last five years and $168.8 billion back through July 1990, according to Federal
Reserve Bank of New York data.
Investors seeking the safety of government debt amid the loss of confidence in
credit markets pushed rates on three-month bills down to 0.387% in January
2009, the lowest level since 1954.
The repo market is the biggest financial market today. Domestic and
international repo markets have grown dramatically over the last few years due
to increasing need by market participants to take and hedge short positions in
the capital and derivatives markets; a growing concern over counterparty credit
risk; and the favorable capital adequacy treatment given to repos by the
market.
Most important of all is a growing awareness among market participants of the
flexibility of repos and the wide range of markets and circumstances in which
they can benefit from using repos. The use of repos in financing and leveraging
market positions and short-selling, as well as in enhancing returns and
mitigating risk, is indispensable for full participation in today's financial
markets.
Unless the repo market is disrupted by seizure, repos can be rolled over easily
and indefinitely. What changes is the repo rate, not the availability of funds.
If the repo rate rises above the rate of return of the security financed by a
repo, the interest rate spread will turn negative against the borrower,
producing a cash-flow loss.
Even if the long-term rate rises to keep the interest rate spread positive for
the borrower, the market value of the security will fall as long-term rate
rises, producing a capital loss. Because of the interconnectivity of repo
contracts, a systemic crisis can quickly surface from a break in any of the
weak links within the market. (See
The repo time bomb, Asia Times Online, September 29, 2005.)
Repos are useful to central banks both as a monetary policy instrument and as a
source of information on market expectations. Repos are attractive as a
monetary policy instrument because they carry a low credit risk while serving
as a flexible instrument for liquidity management. In addition, they can serve
as an effective mechanism for signaling the stance of monetary policy.
The secondary credit market is where Fannie Mae and Freddie Mac, so-called GSEs
(government sponsored enterprises, or agencies), are traded. GESs were founded
with government help decades ago to make home ownership easier by purchasing
loans that commercial lenders make, then either hold them in their portfolios
or bundle them with other loans into mortgage-backed securities for sale in the
credit market.
Mortgage-backed securities are sold to mutual funds, pension funds, Wall Street
firms and other financial investors who trade them the same way they trade
Treasury securities and other bonds. Many participants in this market source
their funds in the repo market.
In this mortgage market, investors, rather than banks, set mortgage rates by
setting the repo rate. Whenever the economy is expanding faster than the money
supply growth, investors demand higher yields from mortgage lenders. However,
the Fed is a key participant in the repo market as it has unlimited funds with
which to buy repo or reverse repo agreements to set the repo rate. Investors
will be reluctant to buy low-yield bonds if the Fed is expected to raise
short-term rates higher. Conversely, prices of high-yield bonds will rise
(therefore lowering yields) if the Fed is expected to lower short-term rates.
In a rising-rate environment, usually when the economy is viewed by the Fed as
overheating, securitized loans can only be sold in the credit market if yields
also rise. The reverse happens when the economy slows. But since the Fed can
affect only the repo rate directly, the long-term rate does not always follow
the short-term rate because of a range of factors, such as a time-lag, market
expectation of future Fed monetary policy and other macro events. This
divergence from historical correlation creates profit opportunities for hedge
funds.
Investors buy bonds to lock in high yields if they expect the Fed to cut
short-term rates in the future to stimulate the economy. When bond investor
demand is strong, mortgage lenders can offer lower mortgage rates for consumers
because high bond prices lead to lower bond yields. But lower interest rates
leads to inflation which discourages bond investment. Lower interest rates also
lower the exchange value of the dollar, allowing non-dollar investors to bid up
dollar asset prices. Non-dollar investors are not necessarily foreigners. They
are anyone with non-dollar revenue, such as US transnational companies that
sell overseas or mutual funds that invest in non-dollar economies. Unlike
investors, hedge funds do not buy bonds to hold, but to speculate on the effect
of interest rate trends on bond prices by going long or short on bonds of
different maturity, financed by repos.
As with other financial markets, repo markets are also subject to credit risk,
operational risk and liquidity risk. However, what distinguishes the credit
risk on repos from that associated with uncollateralized instruments is that
repo credit exposures arise from volatility (or market risk) in the value of
collateral. For example, a decline in the price of securities serving as
collateral can result in an under-collateralization of the repo.
Liquidity risk arises from the possibility that a loss of liquidity in
collateralized markets will force liquidation of collateral at a discount in
the event of a counterparty default, or even a fire sale in the event of
systemic panic. Leverage that is built up using repos can exponentially
increase these risks when the market turns.
While leverage facilitates the efficient operation of financial markets,
rigorous risk management by market participants using leverage is important to
maintain these risks at prudent levels. In general, the art of risk management
has been trailing the decline of risk aversion. Up to a point, repo markets
have offsetting effects on systemic risk. They can be more resilient than
uncollateralized markets to shocks that increase uncertainty about the credit
standing of counterparties, limiting the transmission of shocks.
However, this benefit can be neutralized by the fact that the use of collateral
in repos withdraws securities from the pool of assets that would otherwise be
available to unsecured creditors in the event of a bankruptcy. Another concern
is that the close linkage of repo markets to securities markets means they can
transmit shocks originating from this source. Finally, repos allow institutions
to use leverage to take larger positions in financial markets, which adds to
systemic risk.
The repo market now big and dangerous
Created to raise funds to pay for the flood of securities sold by the US
government to finance growing budget deficits in the 1970s, the repo market has
grown into the largest financial market in the world, surpassing stocks, bonds,
and even foreign-exchange.
At a time around 1998 when the world's biggest government bond market was
shrinking because of a temporary US fiscal surplus, the market where investors
financed their long bond purchases with short-term loans continued to grow by
leaps and bounds. The $2 trillion daily repo market in 1998 became the place
where bond firms and investors raised cash to buy securities, and where
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