Bank Repo Market Moves Into Focus

March 16, 2010 by · Leave a Comment
Filed under: Industry News 

The Wall Street Journal has a nice little descriptive piece on the repurchase transaction market that bank participate in for short term funding.  The Federal Reserve is testing this out to get back the cash they have injected into the banking system during the height of the Great Recession to purchase the “toxic assets” from the balance-sheets of all major financial institutions to give them the liquidity needed to operate.

I am still skeptical that they will do this in a timely manner if it would threaten the solvency of any banks.  Many of these assets are non-performing and will require write-downs which have been coming very slowly as of late.  This is more symbolic to show the Fed is doing something in my honest opinion.   On the other hand, the FDIC has been talking about the lack of write-downs of the home equity lines and helocs that defaulted or will never be paid back, those are more likely to cause real harm in the banking system.

Wall Street Journal – The revelation that Lehman Brothers used repo shenanigans to hide its true weakness is bringing more attention to the repo market–and not a minute too soon.  The repo market is huge, critically important to the banking system and, as indicated by last week’s bankruptcy-court examiner’s report, subject to abuse. Yet it’s little understood or scrutinized.

There’s a good case that the repo market, which was roiled by the financial crisis, also exacerbated and enabled it. Yet no one seemed to recognize at the time the role that the repo market played, and as long as it’s allowed to operate with little disclosure, regulators and investors won’t be able to spot any future Lehmans until it’s too late.

Repos, or repurchase transactions, are essentially short-term loans. A bank “sells” assets–purportedly those of high quality–to another party with the agreement to buy them back a day or a week or 10 days later. Big banks rely heavily on repos as a source of short-term financing, and the market is about to gain even more importance: the Federal Reserve has indicated it plans to use repos to drain some of the excess cash the Fed pumped into the system during the financial crisis.

But the repo market has always been very opaque. It’s hard to tell–sometimes even for those participating in the market–who’s active in repos, the quality of the assets used or the level of the “haircuts” to the value of those securities that the buyers/lenders demand as the price of doing business. Even the overall size of the market isn’t clear; Gary Gorton, a finance professor at the Yale School of Management, estimates it at $12 trillion.

And, as we learned last week from examiner Anton Valukas’s report, it turns out Lehman manipulated the terms of its repos so as to keep assets off its balance sheet and make it look less leveraged than it really was. The report also says Lehman sometimes used lower-quality assets like hard-to-value collateralized debt obligations as collateral for repos, though repo collateral was supposed to be high-quality.

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