Felix Salmon

The danger of repo

By Felix Salmon
August 6, 2012

Remember how there’s a very good chance that Treasury’s new floating-rate notes are going to be linked to some kind of repo benchmark? Well, here’s another reason that’s a bad idea: the repo market is shrinking fast, at least in Europe — and if it can shrink in Europe, it can do so in the US, as well.

What’s more, we want the repo market to shrink. Gillian Tett, in her latest column, explains that as rules about collateral tighten up, they create what Manmohan Singh calls a “second deleveraging”. But weirdly, Tett thinks that an increased focus and reliance on the repo markets is a good thing in the long term: “a financial system in which transactions are secured on assets is likely to be a healthier system than one which is largely – or patchily – unsecured,” she says, “particularly if that collateral is valued in a regular, disciplined basis”.

This is exactly wrong. Repos are a form of informationally-insensitive asset: they epitomize the paradoxical and ultimately destructive desire on the part of people with money to lend out money but to take no credit risk while doing so. Informationally-insensitive assets are a bad idea in general, for reasons which are probably familiar at this point to most readers of this blog: they breed complacency, tail risk, and deluded, magical thinking. But repos are a particularly bad species of the genus, because they are a direct replacement for old-fashioned unsecured credit.

Lending money in return for interest on that money is a form of investing: one entity, with money to spare, invests that money in a venture which can put it to good use and profit from it. If all goes according to plan, both win. The borrower might be poor but has ideas, and the ability to make money in the future; the investor makes such profits possible.

When you move from a credit-based system to a repo-based system, however, all that changes. At that point, future profitability isn’t enough to get you cash: instead, you need to be rich already, and you need to be able to hypothecate your existing assets to some lender. If we’re talking about the banking system, here, we’re talking about a world in which banks simply cease to trust each other at all, and the answer to all interbank credit questions is “no”. The only way for banks to lend to each other is to either go through some central counterparty, hub-and-spoke style, or else to retreat to the world of repo, where banking prowess counts for nothing and all that matters is collateral quality.

The implications of such a world are already being seen: Tett says that “collateral arbitrage” has now become a profit center at some banks. Far from trying to lend out money to creditworthy borrowers, banks are beginning to make money by gaming inconsistent repo rules. No good can come of this.

And in times of crisis, a reliance on repo markets makes all banks incredibly fragile, and vastly increases the risk to taxpayers should a bank fail. Once upon a time, banks had equity, they had debt, and then they had deposits. If a bank failed, the bank’s equity would be wiped out first, and then its debt. The depositors were senior, which meant there was relatively little chance that the FDIC would have to bail them out.

Now, however, bank debts are shrinking, replaced with repo operations. As a result, when a bank fails, the equity gets wiped out first — and then there’s no cushion any more before the depositors start losing money and need to be bailed out. The rest of the finance world is senior to depositors: they have repo collateral, which makes them secured creditors, and secured creditors are senior to unsecured creditors, even when the unsecured creditors are just mom-and-pop depositors.

The more that the world of finance relies upon repo, the less it relies upon relationships and trust and underwriting and all the other ties which bind. The financial sector can’t afford those ties to be severed: the cost of breaking them, in terms of foregone growth and profit, is far too great. But we seem to be doing exactly that.

Update: See also Carolyn Sissoko, from February,  a great post. h/t Waldman.

9 comments so far | RSS Comments RSS

Felix, repo creditors rank senior to secured lenders in most major financial markets. Both repo and derivatives creditors benefit from so-called safe harbour status, a major privilege that allows them to seize and realise collateral without waiting for a bankruptcy court to determine payouts in the case of a debtor’s insolvency. Safe harbour provisions were greatly expanded in the last decade, arguably the key contributing factor to the credit bubble and ensuing collapse. You rightly point out that repo lenders are paying insufficient attention to the creditworthiness of counterparties.

Posted by Pamery | Report as abusive

http://repowatch.org/2011/04/26/how-will -the-fdic-unwind-repos/

Lenders will not be allowed to unilaterally terminate their repo contracts and seize the collateral, as they would normally be able to do when a repo borrower files bankruptcy.

For banks, I do not believe FDIC permit repo collateral to be counted as underlying equity.

Posted by rootless_e | Report as abusive

Spot on, Felix. I also think that repo should be disaggregated for regulatory purposes into a short-dated financing of a long asset, which would affect the interest rate risk and liquidity analyses when doing stress tests.

I haven’t written about report in a while; it needs to be addressed — it’s getting swept under the rug.

Posted by DavidMerkel | Report as abusive

One other note: better for the US to float off the 3-month Treasury, than repo. Who wants rates rising during a crisis?

Posted by DavidMerkel | Report as abusive

“The borrower might be poor but has ideas, and the ability to make money in the future; the investor makes such profits possible”

What you’re describing is more traditionally (and I would argue appropriately) the realm of equity financing than debt financing. Until the post – World War II era, most debt financing was in fact based largely on lending against assets – generally real assets, not financial assets – but still good collateral. Even now, obtaining a cash flow loan requires – appropriately in my mind – a history of relatively consistent earnings. (Companies large enough to access the bond market are in a similar position.) The basic problem is that a lender can’t take anything like the risks of an equity investor, since a lender’s upside is capped. It takes a whole lot of good loans to make up for one loan that results in a full loss of principal.

Posted by realist50 | Report as abusive

“Until the post–World War II era, most debt financing was in fact based largely on lending against assets”

I’m curious on what sources you base this claim. Domestic bills of exchange were a standard means of business finance in the 19th c. US and Britain — and they were unsecured debt instruments. See, for example, “A History of Banking in Antebellum America” by Howard Bodenhorn or Bagehot’s “Lombard Street.”

Posted by csissoko | Report as abusive

Great! Completely agree, Felix. This is the best blog entry I have ever read recently in your blog.
I know from my own experience. I have once worked in an emerging market country in bond trading.

Posted by CEZMI-DISPINAR | Report as abusive

@csissoko – I will admit that I generalized based on having seen noted that Citibank (or more specifically one of its predecessor entities) popularized lending based on business’s cash flow – as opposed to collateral value – during Walter Wriston’s time there. On the consumer side, the rise in unsecured lending – credit cards – has also been dramatic in the post-World War II era.

Regarding the two works that you cite, Bagehot refers repeatedly to lending against “security” – i.e, collateral – and I see Bodenhorn referencing bills of exchange being secured by the underlying commodity as collateral – e.g., a shipment of corn – so I don’t see these as refuting that most lending was secured by collateral.

More broadly, I’ll reiterate my point that financing “ideas, and the ability to make money in the future” has been and will continue to be the realm of equity financing, not debt financing. If, as those ideas take fruit and a business grows, one needs to finance part of the purchase price of real estate, inventory, or equipment, or receivables from customers, that’s the realm of debt financing.

Posted by realist50 | Report as abusive

Re “bill of exchange”, two quite different ideas are being conflated here. A bill of exchange is not a “secured loan” because it is not a loan of any type whatsoever; it is a payment instrument, consisting of instructions to a third-party bank to pay the bearer (or a named party.) The modern American will be more familiar with a “bill of exchange” as a “check.”

Bills of exchange are substitutes for currency and were widely used in 19th century America because the private currencies issued by its myriad banks were not accepted or were heavily discounted in locations far removed from the issuer.

It is true that bills of exchange were often paired with financing, because the people who wanted to make such payments did not possess the means to pay on their own account. The loans were separate transactions, though, ans as noted by realist50 were secured by the goods they financed.

Posted by Greycap | Report as abusive

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