Thursday, October 4, 2012

Repo transactions and shadow banking

We continue to get questions about the repo markets and the structure of repo transactions. The attached paper from the Financial Stability Board provides a good overview of repo and securities lending markets (including rehypothecation practices).

A repo transaction structure is quite simple.  Here is an example:

A hedge fund buys a high yield bond for $10mm. It then uses this bond as collateral to borrow $7.5mm from a dealer. That means the hedge fund puts up $2.5mm net to control a $10mm bond (similar to buying a house with a 25% down-payment) . The dealer will value the bond on a daily basis and if the bond declines in value, the hedge fund will be asked to post additional cash collateral (similar to a futures market). Most such transactions are overnight and are rolled (re-borrowed) daily. The risk to the hedge fund is that one day the dealer refuses to roll the loan and the fund would need to come up with $7.5mm to repay the bank, potentially forcing it to sell the bond quickly (and possibly at a loss). In fact this is how both Bear Stearns and Lehman failed, as their counterparties refused to roll their repo loans. A more likely scenario however is that the dealer raises the initial margin from 25% to say 30% forcing the fund to put up an additional half a million.

To reduce these risks, some funds (and some leveraged ETFs and closed-end funds) negotiate a longer dated repo - usually under 90 days. This gives the fund more time to find alternate sources of funding or liquidate the bond gradually - should market conditions require it.

Below is a generic diagram of a repo transaction, including the so-called tri-party repo (discussed here).

Source: FSB

One issue that keeps coming up repeatedly (including in this FSB paper) is whether this multi-trillion dollar market represents a form of "shadow banking" (discussed in this article by Dan Freed). In and of itself the repo market is no more a "shadow bank" than say the mortgage market. What makes something potentially a "shadow" banking transaction is the lending institution involved. For example a money market fund lending via repo or in some other fashion is a "shadow bank" because money funds are not bank holding companies. The repo example discussed above however does not represent shadow banking since a hedge fund would typically be borrowing from a registered bank. It's an important distinction.

Enjoy!
Securities Lending and Repos

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