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.