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FRBSF WEEKLY LETTER September 13,1985 Risk in the Repo Market Until the last decade or so, the repurchase agreement or "repo" was an arcane financial transaction familiar only to sophisticated users of the government securities market. Its use has grown rapidly in recent years, however, and since 1982, eleven government securities dealers have collapsed partly as a result of their activities in the repo market. Their collapse has imposed an aggregate loss of nearly $1 billion on investors and precipitated a financial crisis of savings banks in the State of Ohio. No single factor is responsible for the difficulties experienced in the repo market. In some cases, dealer fraud has been alleged, but in other cases, economic events simply have exposed the risks inherent in some repurchase agreements. The repo is a complex legal and economic instrument and investors have not always been aware of the pitfalls in their use. The purpose of this Letter is to review briefly the functioning of the repo market and to explore the sources of its recent problems. The basic repo transaction Although a repurchase agreement may be complex in its details, its basic features are quite simple. In a repurchase agreement, an investor (or dealer) purchases securities from a dealer (or other financial institution) who agrees to buy them back at a future date at a higher price, thereby implicitly paying interest to the investor. A reverse repurchase agreement is the same transaction viewed from the dealer's viewpoint. In essence, a repurchase agreement or "repo" is a mechanism for investing funds, and a reverse repo is a mechanism for borrowing funds. (Most parties in the market describe a transaction from the dealer's point of view. Thus, the above transaction, which both investors and dealers call a "repo", is lending by the investors and borrowing by the dealers.) The role of securities in repos is to provide the lender with a means of securing collateral for the funds he has lent. (Legally, there are important distinctions between true collateralized loans and sequences of purchases and sales. For exposition, we abstract from these differences here.) Should the borrower in a repurchase agreement default on the agreement, ostensibly the lender would be able to sell the securities to cover the default. The duration of a repurchase agreement is at the discretion of the parties involved. It is commonly as short as one day (so-called "overnight repos"), but it may last several days, weeks or even months, in which case it is called a "term" repo. In addition, the parties may not wish to specify the duration of the agreement, but rather allow it to be termin~ted at any time by either party. Such a repo is sometimes called an "open" repo. A variety of investors find repos attractive for they offer a convenient and very flexible means of borrowing and lending, particularly for short periods of time. They are attractive, therefore, to the cash managers or treasurers of financial institutions, local governments, school districts, pension funds and others with fluctuating needs for cash. A local government, for example, could invest tax receipts in a repo for several days prior to a payroll date. The pitfalls There are three basic sources of risk to an investor engaging in a repo. The first arises when transfer of control over the securities may not actually have occurred as the investor expected. Unless the investor takes actual, physical, possession of the securities (or the legal equivalent in the case of book-entry transfers), for example, there is the risk that their existence or their freedom from other liens may have been misrepresented or misunderstood. This aspect of repurchase agreement construction is known as "gaining control" and clearly is important to the achievement of the intended "secured" nature of repo transactions. A second type of risk can arise if, because of changes in market conditions, the market value of the securities involved in the repo has declined during the life of the agreement below that necessary to fully compensate the lender should the securities have to be liquidated. Generally, repurchase agreements contain margin requirements and marking-to-market features designed to protect the lender from this eventuality. A repo lender of $10 million, for example, normally will FRBSF require that securities worth slightly more than this amount be transferred to his possession (perhaps 1 to 5 percent more, depending on the volatility of the securities). This incremental protection is known as the "margin." Additionally, as market conditions change during the life of the repo, the lender can require additional cash or securities to be placed under his control if the value of the original securities falls to where the margin is threatened. For these protective features to be effective, the lender must be assured of a means of accurately valuing the securities to which he has gained control. This process is known as "marking-to-market" and can be quite complex since it involves careful monitoring of interest (and principal, in the case of GNMA and other mortgage-backed securities) accruing to the securities as well as their market value. A final but related source of risk to investors in the repo market arises out of the possibility that the securities dealer may fail for reasons not directly related to the investor's repo. Securities dealers engage in a number of activities and have complex portfolios subjecting them in the normal course of business to risk and, as with all firms, failure. If the securities dealer fails, the investor may be subject to unanticipated lOsses. This is particularly true, of course, if the investor's interest in the securities has not been assured, or if marking-to-market has not occurred systematically or precisely. The capital position of the dealer provides some protection for the investor against mistakes made in theexecution or valuation of the repurchase agreement. It often is difficult for investors to assess the adequacy of dealer capital since many of the dealers are unregulated, eliminating one source of external evaluation. The Federal Reserve System has promulgated voluntary capital adequacy guidelines to stimulate some market discipline in this regard. Rights to securities and achieving control Some of the most widely publicized andserious problems in the repo market have been due to ambiguities in the rightsto securities and to the ability to gain access to the securities when the dealer failed. It is important first to note that there are several ways to effect a repo agreement and that each of these ways implicitly hasconsequences for gaining rights to the securities involved and the quality of the i'control" achieved over the securities. No single method is necessarily "best" in every instance. Rather, each involves a different tradeoff between risk and cost and, thereby, the implicit rate of return on the repo agreement. The first broad class of repo procedures is sometimes referred to as "deliver against payment," or simply "delivery," repo because it involves simultaneous release of the funds and direct transfer of securities control to the lender (or the lender's account at his own bank) in the repo agreement. If the securities can be transferred electronically (which generally is the case with U. S. Treasury securities), then the release of good funds by the lender and the transfer of control tothe securities occurs electronically and simultaneously, resulting in a perfected lien. Non-wireable "securities" (such as commercial paper, certificates of deposit and even individual "whole" loans) also can be exchanged simultaneously with the release of funds through the services of a clearing bank. Since physical paper is being transported, however, such transactions are expensive and inherently limited to the immediate locale. In either case, however, the transaction involvesuback room" and wire service transactions costs not only of the funds but more importantly of the securities transferred. These costs tend not to vary significantly with the size of the transaction and, thus, are economical only for very large repos or those that extend for some time. The second broad category of repurchase agreement procedures involves the use of a specified third party to handle the back room work between two counterparties and to hold the security collateral during the repo agreement. In formal "triparty" agreements, the dealer's custodian usually a large bank - is also under contract to protect the investor. The bank holds the securities in the name of the lender in the repo agreement. This arrangement is only practical if it is to be used repeatedly. An alternative method involves issuance by a bank of a trust receipt for securities deposited with them as part of a repo agreement. In either case, having a third party to the agreement provides a more effective avenue of redress should any problems arise. Such agreements involve expensive bank custodial or trust fees, however, and also require substantial effort to coordinate the relationships among the lender, securities dealer and the bank. Such agreements tend not to be used when small amounts of money are involved in the repo. A third type of collateral arrangement involves relying on the securities dealer (who is also the counterparty in the repo agreement) to continue to hold the securities (typically at a custodian bank) instead of transferring control directly to the lender or to a neutral third party. This makes gaining rights to the securities more tenuous, however, since the custodian does not agree to act on anyone's order but the dealer's. The cost of the transaction is lowered, of course, since the securities dealer can avoid formal transfer of the securities and issues and provide, instead, only informal notification of where the securities reside (e.g., in a bank). Obviously, this is an imperfect transfer of control, exposing the lender to the risk of inadvertent or fraudulent use of the same collateral in several repo agreements. Its use relies heavily on the trust that the repo parties have in one another, and it is referred to, appropriately, as a "trust me" repo. Valuation, margin and marking-to-market In addition to the fundamental problem of obtaining rights to the securities involved in the repurchase agreement, there is the additional problem of ascertaining their value and the volatility of their value over the life of the repo agreement. Problems arise here in a number of ways. The securities involved may be thinly traded, making it difficult for the lender to ascertain the market value of the security quickly. The more complex the instrument - in terms of call provisions, principal repayment characteristics, and so on - the more difficult the valuation problem becomes even if underlying credit risk can be assessed accurately. In addition, interest accrual patterns vary widely among financial instruments and it is important that the effects that accrued interest have on the value of the security be assessed accurately and be appropriately liened. The problem of valuation, of course, is most difficult in the case of individual, whole loans such as mortgage loans, which often are not marketed. The valuation problem is particularly difficult iithe securities are long-term ones. Longer term securities exhibit greater price volatility, and the value of the collateral can change rapidly even though the repo agreement itself may be shortterm. The lender must determine the appropriate margin requirement and, just as importantly, how aggressively he intends to require marking-tomarket of the collateral. All of these considerations inevitably involve a tradeoff between risk and return, since failure to obtain adequate margin implicitly leaves the lender subject to risk. To avoid these risks, participants (or their agents) must bear the additional cost of accurately monitoring the value of the securities involved and determining appropriate margin requirements. It is important to emphasize that margin and marking-to-market considerations also apply in the case of a reverse repo. In this case, the borrower must be careful not to allow too much collateral to be transferred to the control of the dealer from whom he is borrowing. Remember, in almost all cases, should the dealer go bankrupt, the value of the collateral given up will exceed the value of the funds lent. In 1982, institutions that had borrowed from dealers found themselves in just such a position because they had failed to consider the value of accrued interest when valuing securities transferred to the control of the dealer, who ultimately went bankrupt. Even more recently there have been losses associated with overcollateralization in reverse repos. Risk vs. return The essential lesson of the repo market is one basic to economics. Namely, return is increased only at the assumption of greater risk. Because many of the costs involved in the repo market do not depend on the size of the transaction but on collateral arrangements and the number and complexity of securities involved, small lenders in the repo market face a different risk-return tradeoff than large investors. (Incidentally, a $10 million overnight repo probably would be considered relatively small by most securities dealers.) Yet small investors - municipalities, school districts, thrifts often overlook this essential fact of the repo marketplace. They are drawn into transactions by attractive yields and do not assess risk accurately. It is only recently that the hazards of ignoring these tradeoffs have become painfully apparent. RandallJ.Pozdena Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo~6U!ljsom oljoPI ljo~n U060JO !!omoH O!UJoJ!l0) ouozPl:I O)SI)UOJ::J UOS JO ~uo8 aAJaSa~ IOJapa::J ~uew~Jodea BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and liabilities Large Commercial Banks Loans, Leases and Investments l 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities 2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Two Week Averages of Daily Figures Amount Outstanding 8/28/85 192,992 174,582 50,879 64,195 35,559 5,434 11,324 7,086 196,672 45,753 31,251 13,575 137,344 - - - 484 576 332 33 191 8 177 85 44 3 196 62 22 45,104 51 38,152 22,612 48 471 Period ended 8/26/115 Change from 8/29/84 Dollar Percent! Change from 8/21/85 - 11,370 11,899 1,561 3,308 6,055 396 588 59 9,150 3,176 3,026 1,549 4,424 7,374 - 3,200 2,195 Period ended 8/12/85 Reserve Position, All Reporting Banks Excess Reserves (+ )jDeficiency (-) Borrowings Net free reserves (+ )jNet borrowed( -) 1 91 25 66 12 59 46 Includes loss reserves, unearned income, excludes interbank loans 2 Excludes trading account securities 3 Excludes u.s. government and depository institution deposits and cash items 4 ATS, NOW, Super NOW and savings accounts with telephone transfers 5 Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources 6 Includes items not shown separately 7 Annualized percent change - 6.2 7.3 3.1 5.4 20.5 7.8 4.9 0.8 4.8 7.4 10.7 12.8 3.3 19.5 - 7.7 10.7 4)Joese8
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