After a Financial Flood, Pipes Are Still Broken

 

 

 

 

 This is a slightly longer article than usual but it is about the fifth anniversary of a major economic collapse.

By GRETCHEN MORGENSO

 IT’S been five years since the bankruptcy filing of Lehman Brothers set off the worst economic crisis in the United States since the Great Depression. With the perspective that distance provides, it’s worth asking: Is our financial system safer and sounder today than it was back then?

Many of the nation’s bankers, lawmakers and regulators might well say yes, arguing that safeguards have been put in place to protect against another cataclysm. The voluminous Dodd-Frank law, with its hundreds of rules and new regulatory regimes, was the centerpiece of these efforts.

And yet, for all the new regulations governing derivatives, mortgages and bank holding companies, a crucial vulnerability remains. It’s found in our vast and opaque securities financing system, known as the repurchase obligation or repo market. Now $4.6 trillion in size, it is where almost every financial crisis since the 1980s has begun. Little has been done, however, to reduce its risks.

The repo market, also known as the wholesale funding market, is the plumbing of the financial system. Without it, money could not flow freely, and banks, brokerage firms and asset managers would not be able to conduct their trades and open for business each day.

When institutions sell securities in this market, they do so with the promise that they can be repurchased the next day — hence the “repo market” name. By using this market, banks can finance their securities holdings relatively cheaply, money market funds can invest cash productively and institutions can borrow securities so they can sell them short or deliver them in other types of trades.

Among the biggest participants that provide funding in this market are the money market mutual funds; they lend their cash to banks and other institutions, accepting collateral like mortgage securities in exchange. The money market funds accept a small amount of interest on these overnight loans in exchange for being able to unwind the transactions daily, if need be.

When markets are operating smoothly, most wholesale funding trades are not unwound the next day. Instead, they are rolled over, with both parties agreeing to renew the transaction. But if a participant decides not to renew because of concerns about a trading partner’s potential failure, trouble can arise.

In other words, this is a $4.6 trillion arena operating on trust, which can disappear in an instant.

Both Bear Stearns and Lehman Brothers collapsed after their trading partners in the repo market became nervous and stopped lending them money. For decades, the firms had financed their holdings of illiquid and long-term assets — like mortgage securities and real estate — in the overnight repo markets. Not only was the repo borrowing low-cost, it also allowed them to leverage their operations. Best of all, accounting rules let repo participants set aside little in the way of capital against the trades.

“It was a very unstable form of funding during the crisis and it is still a problem,” said Sheila Bair, former head of the Federal Deposit Insurance Corporation, and chairwoman of the Systemic Risk Council, a nonpartisan group that advocates financial reforms, in an interview. “The repo market is also highly interconnected because the trades are done between financial institutions.”

Some government officials have also voiced concerns recently about risks in the repo market. William C. Dudley, president of the Federal Reserve Bank of New York, referred to the issue in a February speech and Ben S. Bernanke, the Fed chairman, discussed the problems with wholesale funding in a speech in May. The Securities and Exchange Commission published a bulletin in July on the vulnerabilities in the repo market as they relate to money market funds.

Another problem in this market is that only two banks — Bank of New York Mellon and, to a lesser degree, JPMorgan Chase — dominate the business. There used to be a number of clearing banks, as the banks that stand in the middle of the trades are known, but the ranks have dwindled because of industry consolidation.

Unfortunately, these weaknesses remain. “A lot of things have been done to address a lot of specific problems but it doesn’t seem like anything has been done to address the overall problem of institutions losing access to financing,” said Scott Skyrm, a repo market veteran and author of “The Money Noose — Jon Corzine and the Collapse of MF Global.”

Mr. Skyrm said regulators appeared to be tackling the problem through a back door involving capital requirements. For example, new leverage ratios proposed by the international Basel Committee and United States financial regulators would require banks for the first time to set aside capital against the assets they finance in the repo markets. A recent report from J.P. Morgan estimates that under the Basel proposal, the eight largest domestic banks would have to raise $28 billion to $34 billion in capital relating to their repo business.

Banks are likely to consider an alternative: shrinking their repo operations. But the liquidity in this titanic market is essential for the government’s financing of its debt. As the J.P. Morgan report noted, trading volumes in the United States government bond market are closely linked to the amount of repos outstanding. So any contraction in the arena may reduce liquidity in the Treasury market.

SOME experts think that the answer to the repo problem lies in creating a central clearing platform that would allow all participants, not just the banks, to trade directly. Similar platforms have been mandated for derivatives under Dodd-Frank and could be constructed to support the wholesale funding market.

While such an entity would be a too-big-to-fail institution, so are the two banks now serving as intermediaries. And a central clearing platform could be set up as a utility, with officials monitoring transactions and requiring margin payments to finance bailouts in the event of a participant’s default.

Peter Nowicki, the former head of several large bank repo desks, is an advocate of this idea. “Repo is the last over-the-counter market that’s not headed toward central clearing and the Fed should mandate a change,” he said. “Should a large dealer have a problem or the clearing banks have an issue, the repo market could shut down.”

And that, five years after the Lehman collapse, would be an unconscionable failure.