Risky debt use on repo market hits 2008 levels

Financial Times

The use of lower-rated debt in a key US funding market has returned to pre-crisis levels, fuelling fears that the so-called shadow banking system is becoming riskier. The repo market is an important part of the shadow banking sector, which consists of unregulated financial institutions and activities. In the repo market, banks pledge their securities as collateral for short-term loans from money managers and other investors.

The market played a key role in the build-up to the 2008 financial crisis. Banks used toxic assets, such as repackaged subprime loans, to secure trillions of dollars worth of cheap funding.

When the US housing bubble burst, the banks’ trading partners refused to accept such securities as collateral and the repo market rapidly contracted.

However, a study by Fitch Ratings says the proportion of bundled debt being used as security in repo transactions has returned to pre-crisis levels.

Using the repackaged loans can increase risk in the repo market, the rating agency says. This is because the securities may be prone to sudden pullbacks such as the one experienced in 2008.

“These are less liquid, longer-tenor assets that are funded short-term by highly risk-averse lenders,” said Robert Grossman, head of macro credit research at Fitch. “In a period of market turbulence, all of the parties to a repo would be affected,” he added, meaning that both banks and funds could be hit.

About 20 per cent of the collateral used to secure the transactions now comes from “structured finance”, or repackaged loans, Fitch said in the report.

Almost half of the bundled debt is made up of riskier residential mortgages, including subprime.

The reason behind the resurgence is difficult to pinpoint, Fitch said. It may reflect a shortage of safer securities or the need to secure funding for an inventory of assets. “It could reflect a thawing of structured finance,” said Mr Grossman. “But it could also be a strategy to increase yield, or a combination of things.”

Money market funds, where business models are under pressure from extremely low interest rates, might accept riskier debt as security for their short-term loans because doing so can generate a higher return.

According to Fitch, repos backed by structured debt typically yield more than 50 basis points. Those backed by US Treasuries and agency debt might be deemed safer but they yield just 5 bps and 15 bps, respectively.

The Fitch study is based on repo data sourced from the 10 biggest money market funds in the US, encompassing about $90bn worth of repo transactions.

The actual US repo market is worth $1.6tn, and many of the smaller funds only accept government-guaranteed securities, such as Treasuries, in exchange for their loans.

The Federal Reserve has set up a special task force to work on a plan to scale back systemic risk in the repo market and reduce its dependence on JPMorgan Chase and Bank of New York Mellon, the biggest clearing banks in the US triparty repo system.

Still, others disagree that the use of structured finance in the US repo market will automatically increase risk.

“The underlying performance of many of these deals has been excellent and shown great stability through the crisis,” said Mark Hale, chief investment officer of Prytania Investment Advisors. “If the improvement in confidence spreads further, then the use of structured finance could become a self-reinforcing, positive force easing pressures on the financial system and the underlying consumer and corporate credit conditions.”


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