Regulation wrongs repo

November 23, 2009

The amendment is not very long: only 24 lines in the House’s mammoth draft legislation aimed at saving the financial system from itself. Still, it threatens to make an outsized impact on a critical source of market financing.

Representatives Brad Miller of North Carolina and Dennis Moore of Kansas have proposed putting secured lenders on the hook, should a failed big bank need more capital than it has on hand. On paper, it’s perfectly reasonable — after all, shareholders and creditors should be first in line to pay for some of the losses, not taxpayers.

Under the proposal, any assets pledged to back a secured loan “may be treated as an unsecured claim in the amount of up to 20 percent as necessary” to cover any losses of a bank in receivership that the government or resolution fund would incur.

That means a secured lender can only be sure to hold onto 80 percent of the collateral, with the remainder dependent on the going recovery value for unsecured debt. Lehman Brothers’ unsecured debt was worth less than a dime for every dollar, while Washington Mutual’s fetched only 57 cents, based on the settlement of credit default swaps following their respective failures.

Yet applying this broadly to all banks would also ensnare the repo market — $2.7 trillion worth of financing that greases the wheels of such mainstay markets as U.S. Treasury debt and mortgage bonds backed by housing finance giants Fannie Mae and Freddie Mac.

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to. When financial markets sour, investors pour into Treasuries not just because they believe the government will repay its debts, but because they can.

Under the Miller-Moore amendment, repo lending could also be vulnerable to a sizeable haircut should a financial institution fail. Blogger and colleague Felix Salmon has done some math here and says why he thinks it’s not such a bad idea here.

But introducing the risk of any such loss undermines the market, since the collateral backing the loans is supposed to be risk free. To be sure, this isn’t a completely safe market. At the height of the financial crisis, investors borrowing the securities didn’t return them when the loan expired, resulting in an unprecedented number of so-called fails.

The amendment also raises the possibility that it will create exactly what it’s hoping to stop: a run on a big bank. Joe Abate of Barclays Capital notes that secured lenders will hardly wait around for a bank to enter receivership; they’ll start cutting their repo transactions with a bank at the first whiff of trouble.

If lawmakers want to make the financial system stable when trouble strikes again, they should start with the basics — require bigger capital cushions at banks that need to be much smaller. Then let markets sort out the minutiae. If they still want to tinker, take up a hobby instead.

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