Tuesday, September 18, 2012

Nothing "puzzling" about higher haircuts in bilateral repo markets

At times certain research from the Fed seems to be disconnected from reality. The NY Fed's recent analysis for example compares repo haircuts between bilateral and triparty repo (see discussion on triparty repo) transactions for different collateral types during the 2008 financial crisis. They found that bilateral haircuts were materially higher and varied by collateral type.

Source: NY Fed

And while the results make sense, the researchers' interpretation does not. They entitled the article "The Odd Behavior of Repo Haircuts during the Financial Crisis".
NY Fed: - The different behavior of haircuts in the bilateral and tri-party repo markets is puzzling. These two markets are similar, with both using the same contractual form and the same types of collateral. The purpose of some transactions in both markets is similar—market participants have stated that financial entities use the two markets for funding purposes. These two markets are also tightly linked; the larger securities dealers operate in both markets and often provide intermediation services by rehypothecating into the tri-party repo market collateral received via bilateral repos. These linkages suggest that haircut behavior across the two markets should be similar.
Clearly they don't seem to be aware of what actually transpired in 2008. When a firm (a hedge fund, a mutual fund, an insurance firm, a broker dealer, etc.) lent money to Lehman via repo on a bilateral basis, Lehman placed the collateral for this loan into the lender's securities account - at Lehman. Once Lehman filed for bankruptcy, it would not pay back the money borrowed. The securities account where the collateral was sitting however was frozen by the court. By the time the lender was able to access her collateral and sell it, it had sometimes declined in value so much that the proceeds did not cover the loan balance.

On the other hand if the collateral was held by a third party such as State Street or BoNY, as soon as Lehman couldn't pay, the lender was able to access and liquidate the collateral. Thus the differences in haircuts are not driven by the repo agreement itself - which is what these researchers seem to be focused on. It's driven by the fact that in a bilateral agreement it may take longer to access the collateral and liquidate it, potentially increasing losses. That risk of a longer liquidation period in the case of a default increased the bilateral haircut levels.

As one would expect, the riskier the collateral the higher the risk differential because while an extra few days may not make a difference for treasuries or agency MBS, it could be tremendous for a subprime tranche. And in 2008 no financial institution seemed immune from filing for bankruptcy, potentially resulting in frozen securities accounts. Therefore these risk premiums in the bilateral repo markets were perfectly in line with the expectations.

There should be nothing "puzzling" about this difference in haircuts. What is somewhat puzzling however is how central bank researchers who are disconnected from the realities of financial markets are given an opportunity to influence financial regulation and monetary policy.

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