Daily News: May 13, 2013

Fitch: Risk Assets Remain Prominent in U.S. Triparty Repo

Fitch Ratings’ analysis of newly released data from the Federal Reserve Bank of New York (FRBNY) shows that, as of April 9, almost $300 billion in nongovernment securities were financed through the U.S. triparty repo market, a level that has remained relatively constant over the past few months. Senior government officials and agencies have been warning about the potential systemic risks of funding less liquid assets through short-term wholesale funding markets, such as triparty repo. Importantly, while FRBNY data and money market fund disclosures help to shed light on the risk attributes of the triparty repo market, there is much less information available on the more opaque bilateral repo market, whose overall size remains unclear and is the subject of ongoing research and debate.

The roughly $300 billion in nongovernment repo collateral consists of about $109 billion in equities, $68 billion in corporate bonds, and $76 billion in structured finance (with the remaining $44 billion in collateralized debt obligations, municipals, and whole loans, among other securities). Triparty repo remains an important source of funding for a range of asset classes, including Treasury and agency securities, which make up the balance of the $1.79 trillion U.S. triparty market. For context, the $76 billion in structured finance securities is typically 10 times greater than average daily trading volumes for this asset class.

According to Fitch’s recently published analysis of the ten largest U.S. prime money market funds’ (MMFs) disclosures, structured finance repo collateral typically comprises deeply discounted, small-sized legacy securities. More than half of Fitch’s structured finance sample consists of legacy-era subprime and Alt-A RMBS and CDOs. Additionally, Fitch’s research indicates the generally small size of many of these securities, which could make it difficult for holders to either fund or liquidate them during periods of market distress.

Yield differentials likely help to explain the persistence of structured finance repos. Fitch’s data indicates that, as of end-December 2012, repos backed by structured finance securities yielded approximately 63 basis points (bps) per annum, contrasted with the 17 bps yield on repos backed by Treasurys. Given the continuing low-yield environment, these higher returns are likely attractive to some money funds, which focus primarily on the strength of the counterparty rather than on the collateral when entering into these types of repos. For securities dealers, repos provide a source of cost-effective funding, particularly given the low credit quality, small size, and longer-tenor of many of the underlying securities.

That said, senior government officials and policymakers have recently pointed to the potential systemic risks of funding longer tenor assets through the short-term wholesale funding markets. In a May 3 speech, Federal Reserve Governor Tarullo said, “Repo, reverse repo, securities lending and borrowing, and securities margin lending are part of the healthy functioning of the securities market. But, in the absence of sensible regulation, they are also potentially associated with the dynamic I described earlier of exogenous shocks to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls, and fire sales.” Similarly, the Financial Stability Oversight Council’s recently-published annual report for 2013 cites “fire sales and run risk vulnerabilities” as a potential emerging threat, noting that, for triparty repos, “the risk of fire sales is heightened when collateral is less liquid.”

As Fitch has highlighted in prior research, the use of repo to fund less-liquid assets creates potential risks for both triparty repo borrowers (i.e. dealer banks) and the underlying asset class. Money funds, which act as repo lenders, are short-term, highly risk-averse investors. Repo funding for structured finance assets essentially evaporated at the height of the U.S. credit crisis, a loss of liquidity that likely contributed to the steep valuation declines in this asset class during that period.

To read the Fitch report click here.