“TARP Fee” to Restrict Repos, A Big Source of Funding for Dealers

Early on in the TARP fee discussion, we mentioned in passing that it would probably have an impact on repo financing.

Repo means “sale with agreement to repurchase.” It’s a pawn-broker-like procedure that involves securities. The borrower gets to park his holdings with another party, with an agreement to buy them back at a specified future date, with interest, and gets the market value of the instrument back, less a haircut. There are more bells and whistles, but that’s the basic idea.

For the borrower, it’s an ready source of cash, or securities eligible for repo can be used as collateral. For the lender, it’s an alternative to deposits (in theory, a party with cash, like money market fund, is better secured holding a short-term secured loan than having large, unguaranteed deposits in a bank).

Once upon a time, only Treasuries were accepted for repos. But as the derivatives market exploded, so to did demand for collateral (the party who might need to make a payment has to post collateral to prove he can make good on his exposure, with the amount of collateral adjusted if the value of his obligation changes by more than a certain amount). So other types of AAA paper began to be used for repos. As dealers learned to their sorrow, not all AAA paper was created equal. Our favorite nemesis, 2006 and 2007 vintage AAA-rated asset backed securities CDOs, turned out to be pretty close to worthless.

So as expected, the TARP fee will make repo finance more expensive (in this low-yield environment, uneconomic). The financiers must have their leverage, so they are howling.

Now getting the big broker dealers to operate with less leverage is a good idea. This TARP fee could be viewed a back-door measure; raising equity requirements for broker-dealers would achieve a similar result. But the banksters are addicted to cheap leverage, and will fight this restriction tooth and nail.

But the odd bit here is that Team Obama appears not to have considered the impact on the repo market. If so, this is an astonishing oversight. And if the Administration decides to exclude repos, which for big broker-dealers prior to the crisis, was often 50% of their borrowings, pray tell what was the point of taxing non-deposit liabilities in the first place?

From the Financial Times:

The Obama administration’s proposed bank levy is threatening the $3,800bn repurchase market…

The potential impact of the $90bn, 10-year levy on the repo market could also complicate Federal Reserve efforts to drain the huge amounts of liquidity it injected into the financial system during the crisis…

Wall Street executives say the proposed levy, which would charge banks a 15 basis point fee on their liabilities minus insured deposits, will prompt them to reduce repo exposure to cut short-term liabilities.

They say the profit they make on repo contracts – about five basis points – would be wiped out by the levy, making repo transactions loss making…

Brad Hintz, an analyst at Bernstein Research, estimated in a recent note to clients that banks could reduce their levy’s bill by about 10 per cent if they scaled back their involvement in the repo market.

But other analysts say a reduction in banks’ involvement in the repo market could be consistent with the levy’s aim of reducing financial groups’ reliance on short-term funding.

A reduction in repo activity could create problems for the US Treasury, which uses the market as an important conduit to sell bonds used to fund its deficit.

“Most of the repo market is associated with Treasury financing and this will make the market function less efficiently,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

The Fed has also tested “reverse repos” – selling assets such as Treasuries to bankers for cash, with an agreement to buy them back later at a slightly higher price – as part of its exit strategy from the stimulus provided during the crisis.

Yves here. Can this gang shoot straight? Or is this yet another “appease the peasants” announcement that was planned from the get-go to be neutered later?

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  1. Francois T

    Yves here. Can this gang shoot straight?

    Say what? With Geithner and Summers around, this is akin to ask if water is wet or is the Pope protestant.

    When it comes to econ 001, this Administration act like the proverbial firing squad circle.

  2. Thomas Barton, JD

    Yves, your final question is the absolute answer. This gang can shoot straight. It’s called diversionary fire whilst their TBTF cronies flank right and hope for a Barney Frank style 5 year dead zone for America. Look at how many so-called Democratic Senators will protect Bernanke..Protect Bernanke creates more delay and obfuscation.. This is playing out like our version of Japanese Kabuki Greater Economy Immolation.

  3. Sundog

    Do I have this right? The very cheapest funding is in the overnight repo market. Bear Sterns was rolling $75 billion every night in early 2008 and leveraging at 50:1 according to Cohan. When the haircuts on Bear’s AAA RMBS were bumped up a bit, they were toast.

    The authorities want to move the broker/dealers (which are all now bank holding companies and have access to the Fed window and hence the potential to create taxpayer liabilities) away from wholesale funding in general and especially away from short-term funding based on funny paper that can result in a firm going bust over a weekend.

    I see no reason why an exception for Treasuries couldn’t be accommodated. According to Cohan, it was when GSEman Squid suddenly and massively raised haircuts that the Bear hedge funds went tits-up in summer 2007 (which many seem to mark as the beginning of the Mess), and GS similarly led the way raising haircuts in the run-up to Bear’s failure. The paper Bear was putting out for repo was, of course, highly rated RMBS not Treasuries.

    Shrinking B/D’s access to the short-term repo market, and driving down incentives to create paper that competes with Treasuries in that market, seems worthwhile. I commented a long time ago on this blog that it seems to me the FIRE sector created a machine to generate USD AAA paper which got out of hand and created this Mess.

    See Ricardo Caballero on this angle.


    From the FT article: “A reduction in repo activity could create problems for the US Treasury, which uses the market as an important conduit to sell bonds used to fund its deficit.” Yo no sabe. What problems? Konstam says less efficiency, which is the sort of thing one hears from proponents of high frequency trading. I lean toward the unfashionable Taleb in thinking systems over-optimised for efficiency are brittle, and given the complexity of finance we should lean toward resilience.

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