Four years after US Repo market cracked triggering the global financial run, Federal Reserve is still grappling to understand the size and scope of the Repo market, an area that is outside the regulatory framework (shadow banking) but one that looks to be posing significant systemic risk.

“Gauging the size of the repo market segments clarifies the importance of what we know and do not know….we have very little information about the bilateral market… it would be valuable to know the type of collateral financed in that market and at what terms. This knowledge could give policymakers a better view of possible risk buildups,” states latest NY Fed research post.

So far, securities dealers have been identified as the figures to watch because they are present in every step in the flow chart above. Of particularly descriptive note (multiplier risk!) is the reuse of collateralized securities for more loans.

“Not surprisingly, it is not uncommon for dealers to reuse the securities they have received as collateral in segment 5 as collateral for their own borrowing in segments 2 or 3,” note authors.

This multiplier risk is surely affected by the rating quality of the security traded so as these ratings deteriorate as they are now so should the multiplier effect. Figuring this looks cumbersome when the Fed is grappling with just getting some sense on the size of the repo space.

While this post uses its finding about the tri-party repos that “improves upon the $10 trillion” estimate of the repo space, the post, deliberately or not, is strongly suggestive that the Fed is sniffing hard into Repos and that eventually they want to get a grip on it: why else would a policy group sniff at “possible risk buildups”.

Issues in the repo market have hit real estate investment trusts (REITS) on Friday as stocks in names like Annaly Capital (NLY) and Invesco Mortgage Capital (IVR) went down big early in the day but moved back up as hopes of a debt-ceiling deal spread.

REITs finance their Agency MBS purchases by borrowing at the repo market, so signs of tremors in repo, particularly any haircuts there, could force these REITs to sell the MBS.

Agency MBS are bonds guaranteed by a government sponsored enterprises like Fannie Mae or Freddie Mac and are considered most liquid and a benchmark for mortgage rates. Forced selling of this paper could send mortgage rates higher.

There were no haircuts and as Credit Suisse analysts says “Down payments on mortgage-bond and Treasury repo ‘are unlikely to rise barring a spike in price volatility and/or a sharp decline” in values’”… and this is exactly what’s at risk as debt-ceiling issues mount, always volatility at first.

Wonder what relative value hedge funds are thinking of doing as the volatility keeps splashing here and there?

Washington’s political drama over debt-ceiling and a debt reduction plan has spilled over yesterday into the repo market, the same one that choked the US economy in 2008 after Lehman collapse.

With the rate for overnight repo transactions moving to 0.1% on Wednesday from 0.01% just days before the repo market is signaling that it may be setting up for a choke.

From Wall Street Journal:

But, in recent days, the debt-ceiling standoff and rising yields on Treasury bills have sparked concerns among some lenders. Traders say some corporations and institutions have pulled away from repos, preferring to hold cash amid the uncertainty, and repo transaction volumes have fallen as a result. Other lenders are demanding higher interest rates on the cash they provide in repo transactions to compensate for potentially higher price volatility among Treasuries.

So what is the big deal?

If collateral cost is already increasing just by the anticipation of the credit downgrade, then the chances increase that the repo market may indeed choke up more severely if Washington does cause the credit downgrade.

Some analysts are already talking about a more drastic short-term rise in collateral requirement (called haircut) from $102 to $103 in Treasury collateral demand to get $100 cash. In fact, Nomura warned yesterday that the credit rating downgrade would “potentially freeze up repo liquidity all together”.

At about $4 trillion, repo market matches those with cash with those who need it. Those who need cash have to put up Treasuries as collateral, say $102 worth of Treasuries for every $100 in cash. Borrowing is done in the afternoon and debt settlement, called unwind, is done in the morning. The time in between is bridged by banks providing loans to those in need of a loan rollover.

This framework exposes the repo market to two layers of financial danger.

The immediate one is the seizure of “bilateral” borrowing towards which we are already trending as “repo transaction volumes have fallen”. The transaction seizure may leave many corporations cashless who up to now have thought that the Treasuries they have are sufficiently good collateral to meet their emergency cash needs. These cash needs may arise because firms receivable revenue may come days after they, say, have to cut the paycheck we all look forward to.

In anticipation of repo market freeze, corporations are already hoarding cash:

Many companies, chastened by the turmoil in short-term credit markets after the collapse of Lehman Brothers Holdings Inc. in 2008, were already holding more cash than usual. The prospect of trouble in the all-important market for Treasurys is only adding to their worries.

The second repo freeze effect is the wider banking contagion arising from banks bridging, known as tri-party – the bank is the third party between the borrower and the lender.

Because banks act as finance bridges between the debt settlement in the morning (called unwind) and the borrowing that occurs in the afternoon, banks may suddenly find themselves unable to get out of that guarantee because the next morning those with cash may have decided not to lend because the downgraded Treasuries are no longer of sufficient quality for them.

… and this one is the real choke because even if borrowers could meet the higher collateral requirements banks may not engage in tri-party deals because they are stuck in so many non performing ones already.

As coincidence would have it, NY Fed last week published a paper discussing this very same problem noting that “the market will be more fragile than necessary” as long as the unwind bridge is not linked.

“The bad news is that the reform task force acknowledged unspecified delays in eliminating the unwind. As a result, the goal of linking the settlement of maturing repos to new repos and greatly reducing the need for credit provided by the clearing banks will not be realized as early as expected,” writes NY Fed’s analyst Antoine Martin.

Incidentally, Treasury collateral is going up in other markets as well indicating that they are already losing in value.

On Monday, citing volatility, CME told traders that they need to put up more Treasuries as collateral if they want to do futures trading.

“As per the normal review of market volatility to ensure adequate collateral coverage, CME Clearing will implement the following collateral haircuts effective with the close of business on Thursday, July 28, 2011,” wrote CME in a note to the futures traders.

T-bill collateral was raised 50 basis points, while T-notes and T-bonds went up for a 100 basis point haircut across the yield spectrum.

If CMEs move is indicative of a possible 1% move in treasury yields, it sure does not bode well for the money markets (MMF) where such a yield spike could erode their net asset values (NAV) towards that dangerous threshold of $0.995.

But MMFs may be the next story.