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See also Federal Reserve, Federal Reserve Bank of New York, Lehman, primary dealers, and reform of the Federal Reserve.


Dodd-Frank does not address repo

Although one of the main concerns of the Dodd-Frank Wall Street Reform and Consumer Protection Act soon to be signed by President Obama to law is systemic risk, it is disconcerting that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined. The financial crisis of 2007-2009 to which the Dodd-Frank Act is a response was a crisis not only of the traditional banks, but also of the shadow banks, those non-bank financial institutions that borrow short-term in rollover debt markets, leverage significantly, and lend and invest in longer-term and illiquid assets.

Unlike traditional banks, shadow banks did not have access to the safety nets designed to prevent wholesale runs on banks - namely, deposit insurance and the central bank as the lender of last resort - until 2008. Although there was no wholesale run on the traditional banking system during the crisis of 2007-2009, we effectively observed a run on shadow banks that led to the demise of a significant part of the shadow banking system. Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market. Indeed, the financial crisis of 2007-2009 was triggered by a shadow bank run on two Bear Stearns hedge funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the repo market.

A sale and repurchase agreement as executed in the U.S. is a short-term transaction between two parties in which one party borrows cash from the other by -in effect-pledging a financial security as collateral. From the point of view of the borrower of cash, this transaction is called a repo, whereas from the point of view of the lender of cash, it is called a reverse repo. Although loans secured by some collateral have been traced back at least 3000 years to ancient China, repos as we know them were introduced to the U.S. financial market by the Federal Reserve in 1917 to extend credit to its member banks after a war time tax on interest payments on commercial paper had made it difficult for banks to raise funds in the commercial paper market.

Later in the 1920s, the New York Fed used repos secured with bankers' acceptances to extend credit to dealers to encourage the development of a liquid secondary market for acceptances. Repos fell from grace during the Great Depression after massive bank failures and suppressed interest rates, only to make a comeback after the Treasury-Federal Reserve Accord of 1951 that renewed emphasis on controlling inflation rather than keeping interest rates low...

...The run on the shadow banking system in the repo market came in two phases.

After Bear Stearns collapsed in March 2008, the Fed introduced its most radical change in monetary policy since the Great Depression by extending its lender of last resort support to the systemically important primary dealers through the new "[[Primary Dealer Credit Facility]". However, even this extension of the lender of last resort facility did not prevent the run on Lehman Brothers, as investors realized that this support was not unconditional and unlimited.

With the Lehman bankruptcy on September 15, 2008, the repo market on even U.S. government debt, federal agency debt, corporate debt and federal agency mortgage-backed securities came to a near halt and settlement fails of primary dealers skyrocketed.

When the Fed and the U.S. government let Lehman collapse, the next in line for a run, Merrill Lynch, had to merge with Bank of America. Shortly thereafter, the two remaining independent broker-dealers, Morgan Stanley and Goldman Sachs, were forced to convert to bank holding companies and were formally put under supervision and regulation of the Federal Reserve. In fact, the entire Wall Street system of independent broker-dealers collapsed in a matter of seven months.

The Dodd-Frank Act is completely silent on how to reform the repo market. This is a mistake given the systemic nature of the repo market and its structural weaknesses discussed above.

Unlike the liquidity risk that unsecured financing may become unavailable to a firm, the liquidity risk that secured repo financing may become unavailable to a firm is inherently a systemic risk: the markets for the repo securities held predominantly by the financial sector may become illiquid.

Unless this systemic liquidity risk of repo market is resolved, the risk of a run on the repo market will remain. At any rate, leaving the repo market as it currently functions is not an alternative; if this market is not reformed and their participants not made to internalize the liquidity risk, runs on the repo will occur in future, potentially leading to systemic crises.

US Federal Reserve use of repos

Repurchase agreements when transacted by the Federal Open Market Committee of the Federal Reserve System in open market operations adds reserves to the banking system and then after a specified period of time withdraws them; reverse repos initially drain reserves and later add them back.

Under a repurchase agreement ("RP" or "repo"), the Federal Reserve (Fed) buys U.S. Treasury securities, U.S. agency securities, or mortgage-backed securities from a primary dealer who agrees to buy them back, typically within one to seven days.

A reverse repo is the opposite. The Federal Reserve sells securities to the primary dealers and takes cash "out of the system".

Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint.

If the Federal Reserve is one of the transacting parties, the RP is called a "system repo", but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a "customer repo".

Until 2003 the Fed did not use the term "reverse repo"—which it believed implied that it was borrowing money (counter to its charter)—but used the term "matched sale" instead.

Fed proposes a term deposit facility - "Fed repo"

The Federal Reserve Board on Monday proposed amendments to Regulation D (Reserve Requirements of Depository Institutions) that would enable the establishment of a term deposit facility.

Under the proposal, the Federal Reserve Banks would offer interest-bearing term deposits to eligible institutions through an auction mechanism. Term deposits would be one of several tools that the Federal Reserve could employ to drain reserves to support the effective implementation of monetary policy.

This proposal is one component of a process of prudent planning on the part of the Federal Reserve and has no implications for monetary policy decisions in the near term.

Public comments will be accepted on the proposal for 30 days after publication in the Federal Register, which is expected shortly. The Federal Register notice is attached.

"... For the moment, the proposal is mostly symbolic, said Bert Ely, a banking consultant in Alexandria, Va. He does not consider inflation a significant concern because lending remains weak and banks are still skittish about turning reserves into credit lines.

“It will calm folks down that we’re not going to have this sudden inflationary pressure,” Mr. Ely said. “It gives the Fed a little more control.”

The investments would likely have a maturity of one to six months, and their interest rate would be set through auctions. Banks would not be allowed to withdraw the funds until the term deposits mature.

Currently, banks can earn 0.25 percent on their excess reserves by lending them to other institutions. Banks have been reluctant to lend reserves because of increased pressure from policy makers to keep higher amounts of cash in reserves.

Lou Crandall, chief economist at Wrightson ICAP, said term deposits could emerge as a popular investment vehicle in the long term, though the immediate effect would most likely be subdued.

“Banks would rather show the Fed as a counterparty than another bank,” Mr. Crandall said. “It just looks better in an era when memories of credit problems are quite fresh. And now they earn interest, too.”"

Fed adds money market funds to list of eligible counterparties

Over the weekend we posted a very critical paper by the Minneapolis Fed discussing the potential weakness with the various liquidity extraction mechanisms (in the absence of a Fed Funds rate hike). Today, the Fed goes one step further, after noting increasing pressure by its own members to commence a tightening policy, and has announced the expansion of its reverse repo program with Primary Dealers, by adding additional counterparties. And guess who the first expansion wave focuses on - why Money Market mutual funds of course. Let's just do all we can to drain the money market system asap, shall we.

Statement Regarding Counterparties for Reverse Repurchase Agreements

The Federal Reserve Bank of New York today announced the beginning of a program to expand its counterparties for conducting reverse repurchase agreement transactions ("reverse repos"). This expansion is intended to enhance the capacity of such operations to drain reserves beyond what could likely be conducted through the New York Fed's traditional counterparties, the Primary Dealers. This announcement is pursuant to the October 19, 2009, Statement Regarding Reverse Repurchase Agreements, which announced that the New York Fed was studying the possibility of expanding its counterparties for these operations. The additional counterparties will not be eligible to participate in transactions conducted by the New York Fed other than reverse repos. This expansion of counterparties for the reverse repo program is a matter of prudent advance planning, and no inference should be drawn about the timing of any prospective monetary policy operation.

Fed will conduct small repo "test"

The Federal Reserve said it will test one of the tools for an eventual withdrawal of the central bank’s unprecedented monetary stimulus while stressing that the trials themselves don’t represent any change in policy.

The New York Fed said it will conduct “small scale, real value” three-way reverse repurchase transactions in coming weeks. The tests are “a matter of prudent advance planning by the Federal Reserve,” the statement said, and “no inference should be drawn about the timing of any change in the stance of monetary policy in the future.”

Policy makers led by Fed Chairman Ben S. Bernanke are considering how to withdraw the more than $1 trillion they have pumped into the financial system to combat the deepest recession since the 1930s. Along with raising the overnight bank lending rate, Fed officials have said they may use reverse repos, pay interest on excess bank reserves and sell securities directly to investors to withdraw or neutralize cash in the banking system.

“We don’t think it’s any indication that they’re likely to implement an exit strategy soon, or even in the next several quarters,” said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of 18 primary dealers that trade with the Fed. “It’s important for the Fed to make sure the market is aware that the tools they do have work, even if they’re not ready to use them yet.”

The Fed cut its benchmark interest rate to as low as zero last December and adopted asset purchases as its main policy tool. The Fed is buying $1.25 trillion of agency mortgage-backed securities and about $175 billion of housing agency debt. The Fed in October completed a $300 billion program of U.S. Treasury securities purchases.

Rate Outlook

The central bank probably won’t raise its benchmark interest rate above 0.25 percent until August, according to the median forecast of 45 economists surveyed by Bloomberg News.

The Fed on Nov 4. repeated it will keep interest rates near zero for “an extended period” and specified for the first time that policy will stay unchanged as long as inflation expectations are stable and unemployment fails to decline.

Payrolls in the U.S. probably fell by 120,000 workers this month, according to the median of 67 analysts surveyed by Bloomberg News ahead of a Dec. 4 Labor Department report. The unemployment rate probably held at 10.2 percent, a 26-year high.

The world’s largest economy has lost 7.3 million jobs since the recession began in December 2007. The jobless rate is projected to exceed 10 percent through the first half of next year, according to the median forecast of economists surveyed this month.

Industry/Fed group considers repo backstops

Banks, investors and industry groups last week discussed creating a backstop insurance fund to lessen the risk a distressed dealer could trigger a crisis in the world’s largest funding market.

The discussions took place at a New York Federal Reserve sponsored industry workshop last Wednesday, according to presentations obtained by Reuters.

Participants in the tri-party repurchase market — a key funding source for dealers that briefly seized up during the financial crisis — have been tasked by the central bank with coming up with reforms to strengthen the market which, at its peak, financed more than $2.8 trillion in securities per day.

The market has shrunk from that level since there are now fewer participants and dealers, but it is still the critical finance market for the broader financial system.

Repos, or repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often U.S. Treasuries. In the tri-party repo market, clearing banks JPMorgan Chase & Co and Bank of New York Mellon Corp facilitate trades between counterparties and hold collateral.

After the 2008 collapse of Bear Stearns, the Fed put in place an emergency lending facility for primary dealers. The facility helped stabilize the repo market but was only a temporary fix. It was authorized under a provision of the Federal Reserve Act that allows such lending only when financial conditions are deemed “unusual and exigent.” The facility expired on Feb. 1.

A key aim for the reforms currently under discussion is to ensure the central bank only has to intervene very rarely as a lender of last resort.


The market participants on Wednesday discussed two main proposals for dealing with a defaulted dealer, according to the presentation documents.

Under the first proposal, a so-called emergency bank would step in as a counterparty on a defaulted dealer’s trades to provide temporary liquidity to the dealer’s lenders. Losses would ultimately be guaranteed by an insurance fund similar to the Federal Deposit Insurance Corp, which provides insurance against failed banks.

All dealers would contribute to this FDIC-like fund, paying premiums assessed according to their portfolios and the duration of their tri-party trades, according to the documents.

One concern with this proposal is that establishing a backstop might create an environment in which investors take more risk, according to the documents.

Another issue is whether a privately financed fund can raise enough to protect the market, said Joseph Abate, money market analyst at Barclays Capital in New York.

“The question is … are you trying to insure against the 500-year flood or just provide a temporary liquidity backstop?” he asked. “In an environment where potentially you have a 500-year storm, private insurance may not be sufficient,” he added.

Under the second proposal, a special purpose vehicle (SPV) would take on the troubled portfolio, acting as a new counterparty. Holders of notes issued by the SPV would then ultimately finance the losses of lenders to the defaulted dealer.

A potential drawback to this system would be its limited capacity to offset losses, according to the documents.

In both cases, one of the first lines of defense would remain the margin charges assessed by lenders that determine how much collateral dealers must put up against trades. The Fed’s task force is separately looking into improving margin practices, according to the documents.

The tri-party repo reform task force released initial proposals in December that were focused primarily on operational changes. In a statement on Thursday it said it will release further reform proposals in the first half of 2010.

The group hopes to finish its report by the end of March, according to the documents.

A spokesman for the Federal Reserve Bank of New York said in a statement, “We are encouraged by the progress of the task force to date and the commitment of all participants in their work on these and other repo market-related issues.”

“We look forward to the final results of this exercise in the coming months,” Jeffrey Smith, the spokesman, said.

Tri-party repo task force releases report

The Federal Reserve Bank of New York today announced the publication of a white paper on the work of the Tri-Party Repurchase Agreement (Repo) Infrastructure Reform Task Force. The white paper highlights policy concerns over weaknesses in the infrastructure of the tri-party repo market and seeks public comment on the task force’s recommendations to address these concerns.

The recommendations set forth by the task force in its final report, when implemented, should:

  • dampen the potential for problems at one firm to spill over to others,
  • clarify the credit and liquidity risks borne by market participants, and
  • better equip them to manage these risks appropriately.

Feedback on this paper received during the 30-day public comment period will help New York Fed staff, and others with regulatory and supervisory responsibilities, to assess the task force proposals and identify any additional or alternative measures that should be considered.

“We are grateful for the work of the task force and encourage all stakeholders to provide comments,” said William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York. “The Federal Reserve is committed to initiating actions, as necessary, to promote strong risk management practices by all market participants and the stability and resilience of financial markets more broadly. The work of the task force represents an important step in this direction.”

The tri-party repo market and short-term funding markets will continue to evolve as broader regulatory reforms take shape, and enhancements to infrastructure, such as those proposed by the task force, are implemented. Going forward, it will be imperative to monitor the evolution of these markets closely.

The New York Fed tasked the Payments Risk Committee (PRC), a private-sector group of senior U.S. bank officials sponsored by the New York Fed, to form a group of industry stakeholders to address tri-party repo market infrastructure weaknesses exposed during the financial crisis of 2008 and 2009. The PRC created the Tri-Party Repo Infrastructure Reform Task Force in 2009, and included tri-party repo market participants, service providers and representatives from industry groups. The task force met regularly since its creation to discuss enhancements to the policies, procedures and systems supporting the tri-party repo market. The final report of the task force was also issued today.

The Payments Risk Committee (PRC) today announced the formation of the Tri‐party Repurchase Agreement (Repo) Infrastructure Task Force.

The role of this private‐sector task force is to strengthen the infrastructure supporting the tri‐party repo market to address weaknesses in the market’s ability to function in the face of a severe stress event.

The task force, which first met today, will meet periodically to discuss enhancements to the policies, procedures or systems supporting the tri‐party repo market.

Members will include repo business experts at PRC member firms, major tri‐party repo market participants and service providers, industry groups, and others. The Federal Reserve will provide support and input on technical and policy issues as appropriate.

The Payments Risk Committee is a private sector group of senior managers from U.S. banks that is sponsored by the New York Fed. The Committee identifies and analyzes issues of broad industry interest related to risk in payments and settlement systems. It also seeks to foster industry awareness and discussion, and to develop input on public and private sector initiatives.

New York Fed receives comments all supporting Task Force recommendations

The Federal Reserve Bank of New York is providing the following summary of the 11 public comments it received in response to a recent white paper and to the recommendations of the Tri-party Repo Market Infrastructure Reform Task Force (the Task Force). All comments strongly supported the Task Force’s recommendations that address weaknesses in the U.S. tri-party repo market and contribute to broader financial market resiliency. Comments also suggested additional improvements to the tri-party repo market infrastructure.

The comments focused on the following key themes:

Support for the Task Force’s recommendations to improve operational effectiveness and significantly reduce the level of intraday credit provided by the clearing banks by introducing three-way, real-time trade confirmation; shifting settlement times; automating collateral substitution; and eliminating the clearing banks’ daily unwind. Support for the Task Force’s recommendations to improve margining practices and increase transparency, although some comments cautioned that the recommendations could result in risk management behavior that might not be consistent with a counterparty’s creditworthiness.

Recognition that despite these infrastructure improvements, the potential for a disorderly liquidation might still exist. Several comments noted continuing concerns over the implementation timetables for the Task Force’s recommendations—being either too slow or too fast—and that the identified weaknesses would likely continue until the recommendations were fully implemented. A few comments suggested that although individual recommendations seem reasonable, the cumulative effect of all the Task Force’s recommendations could drive smaller cash lenders from the tri-party repo market.

Other comments suggested requiring a one-day notification of a participant’s intent to terminate a repo transaction; improving the level of detail in existing collateral schedules to support more refined risk management practices; and prohibiting collateral that could not be independently priced—all points that the Task Force either did not consider or did not recommend. Comments also noted the critical role of the two clearing banks and associated competitive and risk concerns, and suggested exploring the benefits and drawbacks of establishing a central counterparty, a central liquidity facility and/or a central liquidation agent.

About the White Paper

On May 17, the Federal Reserve Bank of New York issued a white paper to discuss its policy concerns regarding weaknesses in the infrastructure of the tri-party repo market and on the same day requested comment on the Task Force’s recommendations to address these concerns. The feedback helps Federal Reserve staff, the industry and the public assess the recommendations and identify additional or alternative measures. The Task Force is now reviewing all comments as part of its work to see that the recommendations are implemented.

Federal Reserve collateral margins and valuation

SEC proposes new repo accounting disclosure

Federal regulators voted Friday to propose new rules that could make it harder for financial firms to disguise their level of debt.

The Securities and Exchange Commission is proposing expanded disclosure requirements for the practice of temporarily trimming debt at the end of a quarter to make financial statements appear stronger. The practice is legal but regulators say it can give investors a distorted picture of a bank’s debt and level of risk.

The S.E.C. proposal would require financial firms to report detailed information on their short-term borrowing every quarter. Firms currently are required to disclose that borrowing only once a year.

The S.E.C. commissioners voted 5 to 0 at a brief meeting to propose the new rules and open them to public comment for 60 days. They could be formally adopted them sometime later, possibly with changes...

...Under the proposed rules, banks would be required to report the amount outstanding of their short-term borrowings at the end of each quarter and the average interest rate they paid on the loans. They also would have to report the average amount of borrowings outstanding during the quarter and the average interest rate, as well as the maximum amount outstanding.

Commissioner Luis Aguilar said the expanded disclosure rules are helpful but won’t necessarily prevent deception by firms to make their balance sheets appear less risky than they are.

“Rules on the books are not enough; they have to be enforced,” he said.

FASB floats change to repo accounting

To short-circuit any further Lehman-like treatment of repurchase agreements, the Financial Accounting Standards Board has published a proposed accounting standards update that would more explicitly explain how to account for transactions with an obligation to repurchase an asset.

In Proposed ASU: Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements, the FASB proposes amendments to existing guidance that would affect all companies that transfer a financial asset with both a right and an obligation to repurchase or redeem the asset before maturity. FASB is accepting comments through Jan. 15, 2011.

Companies, mainly financial institutions, commonly use repurchase agreements to manage liquidity. In a typical transaction, a company transfers a financial asset to another party in exchange for cash with an agreement to essentially reverse the transaction at a future date for an agreed price.

The Lehman Brothers bankruptcy examiner exposed some aggressive accounting treatment of repurchase agreements as the financial institution plunged into its epic bankruptcy in 2008. According to the examiner’s report, Lehman treated such transactions as true asset sales and timed them around key reporting dates to mask as much as $50 billion in debt.

Four months later, the FASB opened a project to take a fresh look at the rules around repurchase agreements. FASB Acting Chairman Leslie Seidman said in a statement that during the economic crisis, “concerns were expressed about a narrow aspect of existing guidance for determining whether a repo should be accounted for as a sale or as a secured borrowing.” The proposal intends to address that concern by simplifying the guidance, she said.

The existing rules in Accounting Standards Codification Topic 860 prescribe when an entity may or may not recognize a sale related to a repurchase agreement, with the determination focused at least in part on whether a company has effectively maintained control over a transferred financial asset. The proposed amendments would change the criteria and modify the implementation guidance to make the threshold for sale treatment more clear.

Enhanced margin and collateral for repo proposed

An industry task force is preparing to recommend a series of operational improvements and bigger cushions on margins maintained on collateral, in reforms it plans to seek in the way U.S. Treasury notes and other securities are bought and sold in the “repurchase” market.

In a progress report released Tuesday, the Tri-party Repurchase Agreement Infrastructure Reform Task Force said recommendations will focus on:

  • How to substantially reduce the size of the daily unwind of “repo” agreements and, by association, the size of the secured exposures taken on by clearing banks within each business day.
  • Developing a mechanism for all three parties in a repo agreement – the clearing agent and the buyer and seller -- to match executed trades promptly after execution.
  • Removing trades that are not maturing that day from the daily unwind process
  • Strengthening collateral margining practices, so that haircuts are applied to collateral that has lost worth and greater cushions are created to limit “close-out” risks when transactions are finished
  • Making publicly available reference points for margin levels

In tri-party repurchases, two banks clear the majority of the $5 trillion in cash and securities that underly this Treasury market. They are J.P Morgan Chase and Bank of New York Mellon.

These two banks typically take on the counterparty risk of each repo agreement, by extending credit or collateral to participants. The counterparties are normally two dealers or a dealer and a fund manager.

At peak levels in 2008, more than $2.8 trillion in securities were being financed through repo transactions. According to the task force, many of the repo transactions had “very short maturities” and involved the “daily transfer of nearly the full amount” in cash or securities from the accounts of J.P. Morgan Chase and Bank of New York Mellon.

The task force is comprised of repo experts at major banks working under the auspices of the Federal Reserve Bank of New York. They are hoping to strengthen the system, which came under heavy pressure at the peak of the credit crisis last year.

The group had hoped to release its recommendations by year’s end.

Now, the task force said its work “will benefit from additional discussion with a wider range of market participants and other stakeholders” and “intends to issue its report and recommendations by the end of Q1 2010.”

Repo clearing revamp proposed

(MNI) - After growing somewhat frustrated with the feasibility of doing large-scale reverse repurchase agreements with non-traditional counterparties, the Federal Reserve has begun to focus more on doing these reserve-draining operations with the primary dealer community when the time comes, Market News International understands.

The Fed has been informed by dealers that they would be willing to enter into very sizable amounts of reverse repos with the Fed, if asked to do so, provided they could get some relief from Tier I capital constraints, MNI also understands.

No decision has been made about employing reverse repos and/or other tools as part of an “exit strategy” from quantitative easing. The timing and trigger is still a matter or study and debate, which continued at the Nov. 3-4 Federal Open Market Committee meeting.

There is known to be disagreement as to how much it will be necessary to reduce excess reserves through reverse repos, asset sales or other means in order ultimately to tighten credit and normalize interest rates.

Some officials believe that the Fed’s payment of interest on excess reserves will suffice to accomplish the purpose, contending that if the Fed can effectively raise interest rates the amount of reserves is not that important.

Others put more emphasis on the need to shrink the balance sheet and reduce reserves and the monetary base. And there are those who believe that some mixture of the two approaches will be required, but there is no agreement on the appropriate weight that should be given to interest on reserves and reserve draining at this time.

Reverse repos, in which the Fed sells securities with an agreement to buy them back at a slightly higher price at a later date, have been used by the Fed in the past and have been under discussion for months.

For example, on April 3, Fed Chairman Ben Bernanke said the Fed “can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities.”

Unlike asset sales, reverse repos would not necessarily reduce the size of the balance sheet or extinguish reserves on a permanent basis.

But as a practical matter, the Fed could continuously roll over the reverse repos until the underlying asset matures, thereby effectively making a permanent reserve drain.

Some officials believe the Fed need not resort to large reverse repos or asset sales, arguing that its ability to pay interest on excess reserves will set a floor under the federal funds rate and also enable the Fed to disincentivize banks from lending the reserves into the economy if necessary.

For example, San Francisco Fed President Janet Yellen, an FOMC voter, said recently that “paying interest on reserves is of itself a completely adequate tool to tighten monetary conditions.” Others feel the same way.

But there is doubt among FOMC members and Fed staff whether interest on reserves will be completely adequate given the failure of that program so far to keep the funds rate from trading below target.

What’s more, even though shorter-term Fed liquidity facilities have been shrinking due to less demand, longer term asset purchases promise to continue expanding the balance sheet. This has raised concern among other Federal Reserve presidents who argue that the Fed needs to manage down the size of reserves and the monetary base.

And so the Fed has been looking closely at using other tools to drain or immobilize reserves. Reverse repos have been a particular focus of advance preparation.

On Oct. 19, the New York Fed confirmed that it “has been working internally and with market participants on operational aspects of reverse repos to ensure that this tool will be ready when and if the Federal Open Market Committee decides they should be used.”

And it said “the focus of recent work has been to expand our existing capability to conduct reverse repos with Primary dealers to include ‘triparty’ settlement. This has involved working with the triparty clearing banks and Primary Dealers to implement the necessary changes and updates.”

“We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future,” the New York Fed said.

The New York Fed statement also raised “the possibility of expanding the set of counterparties the Desk might employ for conducting reverse repos beyond the Primary Dealers.”

After initially hoping to be able to do a sufficient quantity of reverse repos with the dealer community, the New York Fed found it necessary to cast a wider net and entered into discussions with money market funds and government sponsored enterprises as potential counterparties.

But Market News understands that the technical and legal challenges of transacting with such non-traditional counterparties has proven somewhat daunting, leading the Fed to return its focus more on the dealer community.

When the Fed sells securities to the dealers as part of a reverse repurchase agreement, it has the effect of reducing their capital to asset ratio below regulatory minimums, limiting the amount of reverse repos the dealers are able or willing to do.

But if the Fed and other bank regulators were willing to grant an exemption from Tier One capital requirements for the reverse repos, the Fed has been informed that the dealers would be willing to do much more than they originally said — perhaps up to $1 trillion.

The Fed is said to be very receptive."

"The Federal Reserve is in talks with banks and securities firms about changing how transactions are processed to reduce risks in the over $5 trillion-a-day repurchase agreement market, according to people familiar with the discussions.

Repos are transactions used for short-term funding, and typically involve the sale of U.S. government debt for cash and the subsequent repurchase of the same or a similar security. In a tri-party arrangement, a third party functions as the agent for the transaction and holds the security as collateral.

JPMorgan Chase & Co. and Bank of New York Mellon Corp. are the only banks that serve in a trade-clearing capacity in the tri-party repo market. Fed Chairman Ben S. Bernanke in a speech on March 10 called for an overhaul of U.S. financial regulations, including “enhancing the resilience of the tri- party repurchase agreement market, particularly as large borrowers have experienced acute stress.”

“The events of the fall highlighted that there are certain gaps in the tri-party repo process that need to be addressed and certain levels of risk management that need to be enhanced,” said Thomas Wipf, chairman of the Treasury Market Practices Group and the head of institutional securities group financing at Morgan Stanley, in a telephone interview from New York. “We wouldn’t be surprised to see recommendations come out of the regulatory community, especially from the Federal Reserve. Based on the work already in progress there might potentially be a plan for going forward that could be laid out in the fall.”

The Fed is considering changes including a central clearing system, the Financial Times reported earlier, without citing the sources of the information.

The Depository Trust & Clearing Corp., which processes most U.S. bond transactions, announced plans on March 12 to expand the central counterparty clearing services and trade guarantees to all parties involved in tri-party repurchase agreements for U.S. government securities in the second quarter.

The Fixed Income Clearing Corp., a subsidiary of the DTCC, is a provider of trade netting, risk management and settlement for U.S. government securities. The New York-based DTCC processes about $3.3 trillion in repos a day.

The Treasury Market Practices Group, which the New York Fed helped form in 2007, includes members that range from securities dealers to hedge funds. The TMPG spearheaded the implementation earlier this year of a 3 percentage point penalty on market participants that fail to make good on delivery commitments for Treasuries in the repo market, after so-called fails surged to a record high last October."

Article from the Financial Times about proposed repo changes

Lehman and repo

NY Fed accepted "bottom of the barrel" from Lehman

They were considered the dregs of Lehman Brothers — “bottom of the barrel,” as one banker put it.

But as Lehman executives tried to keep the floundering bank afloat in 2008, they used these troubled investments to raise quick cash that helped mask the extent of the firm’s troubles. And they did it with the help of the Federal Reserve Bank of New York.

The newly released report on the collapse of Lehman Brothers — which lays out what it characterizes as “materially misleading” accounting at the bank — also sheds surprising new light on Lehman’s dealings with the New York Fed.

Lehman engaged in a series of transactions with the New York Fed that were similar to the ones that drew criticism from the bankruptcy court examiner who investigated its collapse. The examiner, Anton R. Valukas, drew no conclusions about the transactions with the Fed, and focused instead on deals that were known inside Lehman as “Repo 105.”

But the report by Mr. Valukas nonetheless raises fresh questions about the role of the New York Fed in supporting Lehman during the frantic months leading up to its collapse. It suggests that Lehman executives believed the Fed would be able to help the bank avert disaster and provide it with a business opportunity.

“Bernanke and Co. may have ‘saved the day’ ” a Lehman executive, Geoffrey Feldkamp, wrote in an e-mail message to a colleague in March 2008, according to the report. Neither Ben S. Bernanke, the chairman of the Federal Reserve, nor Treasury officials saved Lehman, of course. But it was that month that the Fed started a special lending program open to Wall Street banks like Lehman that could not borrow directly from it. The Fed also lowered its standards for the kinds of collateral that it would accept against such short-term loans.

Lehman, desperate for financing, seized its chance. It packaged billions of dollars of troubled corporate loans into an investment called Freedom CLO. Then, in a series of transactions, it shifted Freedom back and forth to the New York Fed, in exchange for cash. Those moves helped make Lehman look healthier.

Essentially, Lehman was able to temporarily warehouse illiquid investments that were worrying its investors at the New York Fed in return for cash. The Fed created this facility immediately after the near collapse of Bear Stearns. Some suspect that other banks engaged in similar maneuvers.

“There were a number of tricks designed to make their balance sheet look stronger than it was,” said Janet Tavakoli, a structured finance analyst. “And they weren’t alone.”

A spokesman for the New York Fed said the loan facility was created to help the entire financial system and prevent the problems at one bank from cascading. The collateral accepted from Lehman met the Fed’s standards, he added. A third party valued it, the Fed accepted it and then reduced prices to limit the risk..."

Fed repo facility became liquidity source for Lehman

"... When analyzing the Lehman failure, the Lehman Examiner spends a substantial amount of time on the PDCF, and the interplay between it, and Lehman's "assets":

On March 16, 2008, “at the height of the Bear Stearns crisis” the Board of Governors of the Federal Reserve granted the FRBNY the authority to establish the Primary Dealer Credit Facility (“PDCF”)...Under the PDCF, the FRBNY would make collateralized loans to broker?dealers, such as LBI, and in effect, act as a repo counterparty. Unlike a typical counterparty, though, with the creation of the PDCF, the FRBNY was generally understood by market participants to be the “lender of last resort to the broker?dealers.” Reflecting the fact that broker?dealer liquidity had become increasingly dependent on overnight repos to obtain short?term secured financing, the PDCF was structured as an overnight facility.

As to the acceptable collateral qualifier, Valukas notes:

Pursuant to the Federal Reserve Act’s requirement that a Federal Reserve Bank lend only on a secured basis, and according to the convention in repo lending, the FRBNY advanced funds against a schedule of collateral. Collateral accepted by the PDCF initially consisted of: Treasuries, government agency securities, mortgage?backed securities issued or guaranteed by government agencies, and investment grade corporate, municipal, mortgage? and asset?backed securities priced by clearing banks.

Wall Street immediately greeted the arrival of the PDCF as the panacea that would bail out the world.

Citigroup’s Global Markets Equity Research division upgraded Lehman to “buy” on the back of the expansion of the PDCF. Referring to the PDCF, the Citigroup analysis states: “In our view, it’s tough to have a liquidity?driven meltdown when you’re being backed by government entities that have the ability to print money.” The Citigroup analysis elaborated on that point: “With $34b in liquidity at the parent company, [and] the ability to get access to over $200b in liquidity from the Fed’s primary dealer credit facility, . . . access to liquidity is a non?issue.” To Lehman itself, the PDCF seemed like a Bernanke Ex Machina. To wit:

A day after the PDCF became operational, Lehman personnel commented: “I think the new ‘Primary Dealer Credit Facility’ is a LOT bigger deal than it is being played to be . . . .” They mused that if Lehman could use the PDCF “as a warehouse for all types of collateral, we should have plenty of flexibility to structure and rethink CLO/CDO structures . . . .” Additionally, by viewing the PDCF as “available to serve as a ‘warehouse’ for short term securities [b]acked by corporate loans,”5345 the facility “MAY BE THE ‘EXIT STRATEGY’ FUNDING SOURCE WE NEED TO GET NEW COMPETITION IN THE CORPORATE LOAN MARKET.

Amusingly, even Lehman realized the obvious: that the Fed was locked in its "enabler" mode and would now have to serve Ponzi heroin virtually in perpetuity, as it would have no ability to withdraw the extra liquidity:

Feldkamp hypothesized that banks would be able to take advantage of the PDCF’s warehousing potential over the long term, believing the FRBNY could not discontinue the temporary program in the near term, and that the program would eventually become entrenched:

Bernanke and co may have ‘saved the day’, and JPM has a great public affairs approach to make the Bear deal look extremely positive for everyone, by emphasizing how it will be looking forward to applying this new [CDO packaging] technology to [the] resolution of this crisis. Once applied successfully, the Fed will not be able to end the facility. They’ll have to conti[n]ue it and manage it as a standard monetary policy tool.

Forget lender of last resort: everyone now saw the Fed as the "enabler of infinite resort."

Ernst & Young defends Lehman repo 105 auditing

Accounting and Disclosure Issues Relating to Repo 105 Transactions*

There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner _did not_ challenge Lehman’s accounting for its Repo 105 transactions.

As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140.

The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate.

Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) /required /Lehman to account for Repo 105 transactions as sales rather than financings.

The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions.

While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion.

Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment.

If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions*.

Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters.

Lehman's use of repo to disguise insolvency

What is Repo 105 (from Examiner Report's executive summary, footnotes omitted):

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008. Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

The Examiner's Report describes that no U.S. law firm would opine that the accounting treatment for Repo 105 was appropriate.

Accordingly, Lehman moved these transactions abroad:

Lehman first introduced its Repo 105 program in approximately 2001. Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman’s European broker‐dealer in London, under English law. Accordingly, if United States‐based Lehman entities such as LBI and LBSF wished to engage in a Repo 105 transaction, they transferred their securities inventory to LBIE in order for LBIE to conduct the transaction on their behalf.

Lehman increased its reliance on Repo 105 to improve its reported performance:

Lehman dramatically ramped up its use of Repo 105 transactions in late 2007 and early 2008 despite concerns about the practice expressed by Lehman officers and personnel. In an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, Bart McDade, Lehman’s former Head of Equities (2005–2008) and President and Chief Operating Officer (June–September 2008), replied: “I am very aware . . . it is another drug we r on.” A week earlier, McDade had recommended to Lehman’s Executive Committee that the firm set a cap on the use of Repo 105 transactions. A senior member of Lehman’s Finance Group considered Lehman’s Repo 105 program to be balance sheet “window‐dressing” that was “based on legal technicalities.”* Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.

  • Why do lawyers get blamed for accounting technicalities? (editorial comment)

The Examiner concludes that:

a fact finder could find that Lehman’s failure to disclose its use of Repo 105 transactions to impact its balance sheet at a time when both the market and senior Lehman management were keenly focused on the reduction of Lehman’s firm‐wide net leverage and balance sheet, and particularly in light of the specific volumes at which Lehman undertook Repo 105 transactions at quarter‐end in fourth quarter 2007, first quarter 2008, and second quarter 2008, materially misrepresented Lehman’s true financial condition.

Yesterday we asked just who the counterparties on Lehman's Repo 105 transactions were. Today we get our answer: the parties that Lehman used exclusively to mask its true leverage ratio were Barclays, Mizuho, UBS, Mitsubishi, Deutsche Bank, KBC and ABN Amro. This is accompanied by disclosure from the Examiner that these Repos, which should logically have been cheaper to Lehman due to the overcollateralization compared to regular matched repo (remember: 105 instead of 100 plus a minor haircut), in fact were pricier, prompting Lehman staffers such as Mike McGarvey to speculate that counterparties may "try to squeeze Lehman." This is quite a critical development ahead of the lawsuit between the Lehman estate and Barclays (a Repo 105 counterparty), which not only refused to bail out Lehman in the 11th hour, but to subsequently go ahead and in the definition of a fire sale acquire Lehman Brothers' North American brokerage operations for pennies on the dollar, coupled with some serious additional trickery on the side. Another oddity: none of the counterparties were US-based. Did US banks know too well about the imminent collapse of Lehman and thus refuse to participate in the Repo 105 window dressing game? Or, much more relevantly, was Lehman terrified by retaliation of its US-based peers, (be it CDS or stock-based) and as a result refused to open up its deplorable balance sheet to them?

We read from the report:

In the 2007 to 2008 period, Lehman’s Repo 105 counterparties were primarily restricted to Mizuho, Barclays, UBS, Mitsubishi, and KBC, though some of these also tapered off their Repo 105 trading in 2008. E-mail from Chaz Gothard, Lehman, to Mark Gavin, Lehman, et al. (Sept. 4, 2007) [LBEX-DOCID 4553246] (“KBC are no longer able to finance our 105 agency trades. . . . This effectively means we only have 3 counterparts with which to transact this business – Mizuho, Barclays & UBS. Whilst they have taken all the paper we’ve thrown at them to date this situation should not be relied upon.”); e-mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX-DOCID 3207903] (reporting Repo 105 trades with “Barclays – $ 3 billion, UBS – $ 6 billion, Mizuho – $ 2 billion”); e-mail from Mark Gavin, Lehman, to Daniel Malone, Lehman, et al. (May 20, 2008) [LBEX-DOCID 736184] (noting in e-mail with subject line “RE: Repo 105 CPS” that “Mizuho - $5bln,” “[n]o longer at the table: Barclays up to $15 bln,” “UBS up to $10 bln,” “Mitsubishi up to $1 bln,” and “KBC up to $2 bln”);

And some other counterparties attempted:

In February 2008, Lehman found a new Repo 105 counterparty in ABN Amro Bank NV (London Branch). See e-mail from Nirav Patel, Lehman, to Kandy Hosea, Lehman, et al. (Feb. 29, 2008) [LBEX-DOCID 3383394]. Deutsche Bank was also a Repo 105 counterparty to Lehman in 2008. When a Repo 105 transaction with Deutsche Bank failed, Tonucci assigned Carlo Pellerani (International Treasurer) to ensure the problem was resolved. See e-mail from Paolo R. Tonucci, Lehman, to John Coghlan, Lehman (Mar. 25, 2008) [LBEX-DOCID 117336].

So now that we know who the counterparties were, here is how we know that they knew all too well that Lehman was in trouble and could be bled dry, as this was the last recourse the firm had:

Given that in a Repo 105 transaction, Lehman provided its counterparty with more collateral for the same amount of cash as in an ordinary repo, one might expect the interest rate to be lower, as the terms were better for the lender, i.e., had greater protection in the form of more collateral in the case Lehman did not repay its borrowing. The Examiner’s analysis shows that, on the contrary, the interest rate in a Repo 105 transaction was higher than in an ordinary week-long repo despite the overcollateralization. Based on witness statements that Lehman was in a “price taking situation,” and documents such as the e-mail in which Lehman staffers begged to increase the Repo 105 credit line with Mizuho to improve the balance sheet profile at quarter end, the higher interest rate in a Repo 105 transaction was likely a consequence of Repo 105 counterparties being aware of Lehman’s desperation.

Lehman's repo treatment mirrored by Wall Street

"...Let me take you back to 2006 and Bank of America. Pages 94 and 95 of the 2006 Annual Report show (amongst other things) the average total assets by quarter from the fourth quarter of 2005 to the fourth quarter of 2006 inclusive...

...You will notice that the end period assets were always lower than the average assets. Moreover it was not obvious unless you really looked because the quarterly earnings releases did not include average assets (but you could work it out because they stated return on average assets).

It was not just 2006 either – this had been happening for a while. Bank of America was parking its assets off balance sheet at the end of every quarter for some time and had been obscuring the fact.

If Bank of America wanted to shove the assets off balance sheet someone (credit worthy) needed to be found to house the assets overnight. There are not that many parties credit worthy for $50 billion or more of overnight repos.

Well – being an obsessive reader of bank accounts I found the counterparty. It was MUFJ. If you wish to you can show – the same way that MUFJ had end period assets higher than average assets and that the differences and timing roughly match. Someone had to assist BofA in its financial legerdemain and we know the counterparty.

Once – through an interpreter – I asked senior MUFJ executives about this. Any nuance in the answer was lost in translation.

So back to Repo 105

Repo 105 is fraud. Its a lie to investors and rating and regulatory agencies. It was also fraud when BofA did it. But both Lehman and Ken Lewis compartmentalized it as OK. And it was not the fraud that undid them – it was the overweening arrogance that thought this was alright. The same overweening arrogance that made Ken Lewis think it was alright to pay a big premium to close for Merrill Lynch (and later force mass dilution of BofA common shareholders).

But the chief executive (or other executive) who thought this was alright was probably certifiable. Just as certifiable as the Lehman execs who Felix rightly chastises..."

NY AG sues Ernst & Young for Lehman 105

New York Attorney General Andrew Cuomo sued Ernst & Young LLP, accusing the firm of facilitating a “major accounting fraud” by helping Lehman Brothers Holdings Inc. deceive the public about its financial condition.

For more than seven years before Lehman declared bankruptcy in 2008, the investment bank engaged in transactions approved by Ernst & Young whose purpose was to move debt off its balance sheet and make it appear less leveraged, Cuomo said in a statement. This was done through what are known as “Repo 105” transactions.

“This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed,” Cuomo said today in one of his last cases as attorney general. “Just as troubling, a global accounting firm, tasked with auditing Lehman’s financial statements, helped hide this crucial information from the investing public.”

The state seeks to recover more than $150 million in fees collected by Ernst & Young for work performed for Lehman from 2001 to 2008, plus investor damages and equitable relief, Cuomo said. He will be sworn in as New York governor on Jan. 1. His successor will be New York Democratic state Senator Eric T. Schneiderman.

BofA and Citi admit use of "repo 105"

The WSJ reports that, as broadly expected, Lehman is not alone in its illegal Repo 105 window-dressing scam: it turns out that Citigroup and Bank of America also routinely used such shady practices for years. As Michael Rapoport reports, "Citigroup said the misclassified transactions-of $5.7 billion as of the end of 2009, and as much as $9.2 billion over the past three years-involved "a very limited number of our business units" that "used this type of transaction in very small amounts." So its all good - fraud may have been performed but it was just nickel and diming: after all it's not like Citigroup was robbing cemeteries or anything (and since guilt was neither admitted nor denied in that specific case, one can say Citi was never sleeping because it was robbing graveyards but only due to honest mistake).

Sure enough, this disclosure come only after the SEC demanded clarification on Repo-105 comparable transactions at all major firms. And with such daily distractions as ten trillions point swings in the market, and crude oil filling up the world ocean, who really cares anymore that all US banks commit fraud on a daily basis. The punchline: "Bank of America and Citigroup say their misclassifications were due to errors--not an attempt to make themselves look less risky." Well, that surely justifies everything.

More from the WSJ:

"Bank of America Corp. (BAC) and Citigroup Inc. (C) incorrectly hid from investors billions of dollars of their debt, similar to what Lehman Brothers Holdings Inc. did to obscure its level of risk, company documents show.

In recent filings with regulators, the two big banks disclosed that over the past three years, they at times erroneously classified some short-term repurchase agreements, or "repos," as sales when they should have been classified as borrowings. Though the classifications involved billions of dollars, they represented relatively small amounts for the banks.

A bankruptcy-court examiner said Lehman had been doing the same thing to make its balance sheet look better before it filed for bankruptcy in September 2008, using a strategy dubbed "Repo 105" that helped the Wall Street firm move $50 billion in assets off its balance sheet.

Bank of America and Citigroup say their misclassifications were due to errors--not an attempt to make themselves look less risky, which examiner Anton Valukas said was Lehman's motivation. The disclosures, made after federal securities regulators began asking financial firms about their repo accounting, were included in quarterly filings earlier this month but not highlighted.

The disclosures come amid a series of revelations about how banks obscure their risk-taking before reporting their finances to the public, a practice known in the financial world as "window dressing."

Federal securities rules bar financial firms from intentionally masking debt to deceive investors. There is no indication that Bank of America or Citigroup misclassified their repos intentionally or that the Securities and Exchange Commission will take any action against them. An SEC spokesman declined to comment."

Bank of England US dollar repo operations

The Bank of England, the European Central Bank (ECB), and the Swiss National Bank are today announcing their intention to continue conducting US dollar liquidity-providing repo operations at a term of 7 days from October 2009 to January 2010. In light of the generally reduced use of these operations, the central banks listed above intend to discontinue the current 84-day repo operations after a final operation at the start of October.

Bank of England US Dollar Repo Operations

In parallel with other central banks, the Bank of England is today announcing dates for its US dollar term repo operations for End-September 2009 to January 2010. The operations will be carried out as fixed rate tenders with full allotment. The Bank will discontinue the 84-day repo operations, following a final operation to be held on 6 October and maturing on 8 January. The Bank will continue to keep its US dollar repo operations under review in the light of market conditions.

BIS on repo clearing

In a report published today by the Committee on Payment and Settlement Systems (CPSS), central bankers highlight issues related to the clearing and settlement infrastructure for repos that have the potential to affect the resilience of repo markets, and recommend that stakeholders in each market review options to further strengthen the repo clearing and settlement infrastructure.

The report, Strengthening repo clearing and settlement arrangements, first presents a comprehensive survey of the clearing and settlement arrangements for repos in selected CPSS member countries. In particular, it sheds light on the experience with these arrangements during the financial crisis. The analysis shows that repo clearing and settlement arrangements vary considerably across countries and markets.

Second, the report identifies several issues related to clearing and settlement arrangements for repos that have the potential to affect the resilience of repo markets (eg the risks related to the extension of significant amounts of intraday credits within some repo settlement arrangements; the lack of transparency of some repo infrastructure roles, responsibilities, practices and procedures; concerns regarding the protection against counterparty credit risk in repo transactions; and inadequate capabilities for liquidating repo collateral in the event of a cash borrower's default). Due to the substantial variety in repo clearing and settlement arrangements, the identified issues are not relevant to the same extent in each market. Finally, the report outlines options and measures through which these issues can be addressed.

The report concludes that it is worthwhile for the stakeholders in each market to review how the clearing and settlement arrangements for repos could be further strengthened. As a first step, the report suggests that the providers of such arrangements in each country should, jointly with market participants, regulators and the central bank, attempt to develop a common view on the relevance of the identified issues for their market. As a second step, each provider could then evaluate which measure or combination of measures would be best suited to address the relevant issues in its specific circumstances.

Repo collapse at the heart of the financial crisis

"...And now we are ready for Chapter 9, where all the malign forces described in the rest of the book converge into one mighty foul-up. Exhibit One is the Shadow banking system, whose components are: securitization, whereby loans turn into assets; repos, whereby assets are used as security for loans (note that we are now into the dangerous territory sketched out in Chapter 8); and finally, Credit Default Swaps, which guarantee the quality of the loans underlying the assets, and thus the resilience of the repo market; and everything in the garden is lovely.

There are still other elements of the shadow banking system: the notorious conduits (a zoo of abbreviations: SPEs, OBS vehicles, SIVs, CDOs); the money market funds. These are all just thinly capitalized banks, totally dependent on capital markets to fund their activities.

But it’s really the description of mid-Noughties repo that made the light bulbs go on for me. Via the repo market, real banks came to resemble shadow banks, more and more; and their fortunes became intertwined; which was very dangerous. In the good old days, repos were a respectable mechanism for managing liquidity by securing lending against high class assets – Treasuries; the highest quality assets of all. But various new myths meant that there was a ready way to satisfy the massive demand for short term funding driven by the rise of hedge funds and OTC derivative trading during the Noughties.

Myth 1: the false security of the Credit Default Swap, which simply substituted the creditworthiness of the swap seller for the creditworthiness of the debt issuer; myth 2: the credit rating bought from agencies by the debt peddlers; myth 3: the “haircut”, propagated by the Basel II regulations, by which all manner of securities could be deemed suitable collateral for repos, subject only to a finger in the air discount, the ‘haircut’.

The BIS (originators of Basel II) cleared its throat discreetly in 2001, warning that a collateral shortage would cause

“appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

…but no-one was listening. Estimates are hard to come by, but the claim that the Shadow Banking System was just as big as the regulated one by 2006 seems plausible: that’s $10 Trillion in old fashioned deposit based banking and the same again in Shadow Banking. But note: you would have to put pretty wide error bars on that number; the whole Shadow Banking System was unregulated, quite invisible to outsiders.

Its fragile structure did catch the eye of the looters, though. Chapter 9 exposes the mechanism by which one market operator set out to profit from the credit boom, and even more, from the bust. I’m afraid you will have to buy your own copy of the book to get the full details. Suffice it to say that it’s an eye-popping story of vandalism-for-profit, with elements wholly familiar from earlier chapters: it’s the Mexico story and others, all over again; but lots bigger. The lazy or hurried may prefer Appendix 2 as a short form summary, but it’s worth reading Chapter 9 to get the full flavour.

It is illuminating indeed to see the events of September ’08 and after as a near-cataclysmic run not so much on traditional banks as on the shadow banking system, as the Credit Default Swaps turned out to have been written by companies that couldn’t honor their promises, the loans turned out to be of dreadful quality, panicked investors pulled their money from the repo market, and there was a monstrous loss of liquid funding, with the undercapitalization of the banks hideously exposed.

Repo is at the very core of the near-collapse of the financial system. It is very striking that there have been few efforts to reregulate repo – of course, the low quality repo market packed up altogether during the crash, so maybe it’s completely invisible again to those bind and amnesiac powers that be. Partly, this sudden disappearance was the result of a buyers’ strike (still seemingly in force at the end of February 2010 – “fool me once”, they must be thinking out there); partly, though, the result of the Fed’s frantic efforts to plug the huge funding gap that had suddenly (and one suspects wholly unexpectedly) appeared. Yes, well, that’s the sort of nasty surprise you get when you don’t exercise oversight. Will the whole precarious mechanism all come back again when the Fed’s programs are finally terminated and the yield curve slope is no longer such an obliging source of riskless profit? One hopes not, but fears it will be so..."


Complete background at Wikipedia.

A Repurchase agreement (also known as a repo or Sale and Repurchase Agreement) allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest.

In a repo, the borrower agrees to sell immediately a security to a lender and also agrees to buy the same security from the lender at a fixed price at some later date.

A repo is equivalent to a cash transaction combined with a forward contract.

The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower.

The difference between the forward price and the spot price is the interest on the loan while the settlement date of the forward contract is the maturity date of the loan.

Euro repo market now 7 trillion euros plus

The European repo market has grown to a record size, surpassing levels seen before the 2008 financial crisis and expanding 25 percent since December 2009, showing the market is recovering steadily, a study showed on Wednesday.

Repo trades require borrowers to offer collateral as security against a cash loan. The borrower sells the security to the lender and agrees to repurchase it at an agreed time in the future for an agreed price. A snapshot of the total value of outstanding repo contracts showed the size of the market at 6.979 trillion euros at the close of business on June 9, compared with around 5.5 trillion euros six months earlier. The previous record market size was 6.775 trillion euros in June 2007.

The survey, conducted by the European Repo Council of the International Capital Market Association (ICMA), used data from 52 financial groups and also highlighted a shift towards use of central clearing services and a sharp fall in the use of Greek bonds as collateral.

"The results of the survey confirm the continuing recovery of the European repo market and the underlying trading activity that it supports," ICMA said in a press release.

The European repo market contracted sharply on credit concerns after the 2008 financial crisis because banks were reluctant to deal directly with each other.

The share of open repo trades without a fixed end date -- structurally important as a flexible financing tool -- rose to 6 percent from 4.1 percent last December, pointing to improved confidence.

However, the study highlights a growing concentration in the market, with those institutions that emerged relatively unscathed from the financial crisis capturing greater market share.

Over two-thirds of the business covered by the survey was transacted by just 10 firms, well above the historical norm, ICMA said.

This concentration may also exaggerate the headline growth in the market, with individual institutions' position on the day of the survey able to exert a greater influence.


The study highlighted the use of central clearing counterparties (CCPs), which allows banks to remain anonymous when trading repo, with the clearing house assuming the clearing members' counterparty risk.

Of the surveyed trade, 22.4 percent was cleared via CCPs. The study suggests there has been a broader underlying shift towards CCP use, said survey author Richard Comotto.

The use of Greek collateral in repo trades fell from 2.2 percent last December to just 0.4 percent, showing the effect of this year's sovereign debt crisis when investor confidence in the creditworthiness of the country dried up.

Tri-party repo

The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization acts as an intermediary between the two parties to the repo. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral. Tri-party agents administer US$ trillions of collateral. They therefore have the scale to subscribe to multiple data feeds to maximise the universe of coverage.

They are also able to offer sophisticated collateral eligibility filters with which to create eligibility profiles which can systemically generate collateral pools which reflect a Buyer's risk appetite. Collateral eligibility criteria could include asset type, issuer, currency, domicile, credit rating, maturity, index, issue size, average daily traded volume, etc. Both the lender and borrower of cash enter into these transactions to avoid the administrative burden of bi-lateral repos. In addition, because the collateral is being held by an agent, counterparty risk is reduced. A tri-party repo may be seen as the outgrowth of the due bill repo, in which the collateral is held by a neutral third party.

Sell/buy backs

A sell/buy back is the spot sale and a forward repurchase of a security. It is two distinct outright cash market trades, one for forward settlement. The forward price is set relative to the spot price to yield a market rate of return.

The basic motivation of sell/buy backs is generally the same as for a classic repo, i.e. attempting to benefit from the lower financing rates generally available for collateralized as opposed to non-secured borrowing. The economics of the transaction are also similar with the interest on the cash borrowed through the sell/buy back being implicit in the difference between the sale price and the purchase price.

There are a number of differences between the two structures. A repo is technically a single transaction while a sell/buy back is a pair of transactions (a sell and a buy). A sell/buy back does not require any special legal documentation while a repo generally requires a master agreement to be in place between the buyer and seller (typically the SIFMA/ICMA commissioned Global Master Repo Agreement (GMRA)). Typically, sell/buy-backs do not allow for marking to market and margin call, which can result in larger counterparty risks than those of securities lending or repo agreements. Any coupon payment on the underlying security during the life of the sell/buy back will generally be passed back to the seller of the security by adjusting the cash paid at the termination of the sell/buy back. In a repo, the coupon will be passed on immediately to the seller of the security.

A buy/sell back is the equivalent of a "reverse repo".

Securities lending

The general motivation for repos is the borrowing or lending of cash. In securities lending, the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures. Securities are generally lent out for a fee. Securities lending trades are governed by different types of legal agreements than repos.

Reverse repo

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints.

The Federal Reserve's statement on the use of reverse repo

"Numerous Federal Reserve communications have indicated that reverse repurchase agreements are a tool that could be used to support a reduction in monetary accommodation at the appropriate time. Over the past year, the Federal Reserve Bank of New York has been working internally and with market participants on operational aspects of reverse repos to ensure that this tool will be ready when and if the Federal Open Market Committee decides they should be used. This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary policy tightening.

Repos and reverse repos have been in the Federal Reserve's toolkit for years, and the Federal Reserve has conducted both as recently as December 2008. The focus of recent work has been to expand our existing capability to conduct reverse repos with primary dealers to include "triparty" settlement.1

This has involved working with the triparty clearing banks and Primary Dealers to implement the necessary changes and updates. We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future. No actual operations have been conducted as part of these tests.

Recent Federal Reserve communications have also raised the possibility of expanding the set of counterparties the Desk might employ for conducting reverse repos beyond the Primary Dealers. The Federal Reserve continues to study this issue, and no decisions have been made regarding the types of firms that may be included. We will engage market participants on this subject as appropriate going forward.

1 The Fed has conducted triparty repos with the primary dealers since 1999.


For the buyer, a repo is an opportunity to invest cash for a customized period of time (other investments typically limit tenures). It is short-term and safer as a secured investment since the investor receives collateral. Market liquidity for repos is good, and rates are competitive for investors. Money funds are large buyers of Repurchase Agreements.

For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding costs of other speculative investments, and cover short positions in securities.

In addition to using repo as a funding vehicle, repo traders "make markets". These traders have been traditionally known as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk. Elementary matched-book traders engage in both the repo and a reverse repo within a short period of time, capturing the profits from the bid/ask spread between the reverse repo and repo rates. Presently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, and liquidity management.


While classic repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold at the maturity date. In other words, the repo seller defaults on his obligation. Consequently, the buyer may keep the security, and liquidate the security in order to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this credit risk, repos often are overcollateralized as well as being subject to daily mark-to-market margining. Credit risk associated with repo is subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc.

Repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco. Occasionally, a party involved in a repo transaction may not have a specific bond at the end of the repo contract. This may cause a string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument. The focus of the media attention centers on attempts to mitigate these failures.

Market size

The US Federal Reserve and the European Repo Council (a body of the International Capital Market Association) both try to estimate the size of their respective repo markets. At the end of 2004, the U.S. repo market reached US$5 trillion.

The European repo market has experienced consistent growth over the past five years, from €1.9 billion in 2001 to €6.4 trillion by the end of 2006, and is expected to continue significant growth due to Basel II, according to a 2007 Celent report entitled “The European Repo Market”.[1]

Other countries including India, Japan, Mexico, Hungary, Russia, China, and Taiwan, have their own repo markets, though activity varies by country, and no global survey or report has been compiled.


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