Banks Find Few Signs of Default Distress in Repo, Credit Markets
U.S. banks searching for hints of credit-market distress ahead of next week’s deadline to raise the debt ceiling are finding few signs of panic so far.
Commercial banks and securities firms are tracking how money-market funds adjust holdings and whether participants in repo markets, where financial firms obtain short-term financing, change terms for collateral including Treasuries, according to executives in charge of finance operations at five of the largest U.S. banks. They are also looking for disruptions in commercial paper and swaps markets, said one of the people, who declined to be identified because the deliberations are private.
Lenders are making contingency plans in case President Barack Obama and Congress fail to reach agreement before an Aug. 2 deadline. Commercial banks are focused on a potential downgrade to the U.S. debt rating, with a default considered unlikely, said the executives. With less than a week to the deadline, key market indicators have remained stable.
“If the debt ceiling was such a problem, there’d be a lot more volatility in the credit markets,” said Leon Wagner, who co-founded GoldenTree Asset Management LP, a New York hedge fund focused on debt markets. “What we’re seeing is really just statistical bouncing around a normal trend line. That’s healthy in credit markets.”
The average rate for borrowing and lending Treasuries for one day in the repurchase-agreement market was 9 basis points yesterday, according to index data provided by the Depository Trust & Clearing Corp. The rate was 26.6 basis points on Aug. 2, 2010, the data show.
The Libor-OIS spread, a gauge of banks’ reluctance to lend, was 13.4 basis points, up from 12.6 basis points a month ago and down from 28.5 a year ago. A basis point is 0.01 percentage point.
The Republican-led House remains on a collision course with the Senate and the White House over competing plans to increase the debt limit. Obama has threatened a veto of House Speaker John Boehner’s two-step plan to raise the debt ceiling.
Standard & Poor’s, which has given the U.S. a top ranking since 1941, reiterated July 21 that the chance of a downgrade is 50 percent in the next three months. The ratings firm said it may cut the nation as soon as August.
Vikram Pandit, chief executive officer of Citigroup Inc., said he doesn’t expect a default.
“Obviously as a bank we look at all contingencies,” Pandit said in an interview. “We’re ready with a lot of liquidity, funding, and understand the impact of a downgrade, not only on us but what could happen to the economy.”
A downgrade may roil repo markets, where banks and other companies turn to finance holdings and increase leverage, by causing lenders to advance fewer funds against the same amount of Treasuries, raising the so-called haircut, JPMorgan Chase & Co. (JPM)’s Terry Belton said July 26 on a conference call hosted by the Securities Industry and Financial Markets Association. About $4 trillion of Treasuries are used as collateral in the market for repos, he said.
“The more volatile it is, the higher the haircuts in margin requirements tend to be,” said Belton, global head of fixed-income strategy at JPMorgan. “One of the impacts of that in the repo market is it causes the amount of credit that’s being extended, the collateralized lending, to shrink. You force people to de-lever.”
In so-called bilateral repos, the investors involved would set their own terms on potential haircuts or exclude certain securities as collateral. In the cleared market, the haircuts would be set by the DTCC, which processes about $3.6 trillion in repos transactions daily.
“We continue to monitor market volatility in the Treasury market and are assessing if we will need to make any types of adjustments in our valuations of securities required for collateral in our clearing funds,” DTCC spokeswoman Judy Inosanto said in an e-mailed statement. “At this point, this still remains a precautionary exercise.”
In Europe, where the Greek debt crisis has sparked concern other nations may default, LCH.Clearnet Ltd., Europe’s biggest clearing house, increased the extra deposit charge for customers holding long positions in Portuguese and Irish government bonds. LCH said it would scale back the use of Portuguese bonds as collateral after that nation’s credit rating was downgraded.
At least one U.S. bank has moved early to avoid any potential disruption. Capital One Financial Corp. (COF), the McLean, Virginia-based lender completing the $9 billion purchase of ING Direct USA, moved up the release of its second-quarter earnings and a capital raise by about a week. The lender sold $3 billion in debt July 14 and $2 billion in equity a day earlier.
“One of the reasons we chose to do that was to take the financing risk off the table,” Gary Perlin, chief financial officer at Capital One and the former finance chief at the World Bank Group, said in an interview. “Uncertainty is never a good backdrop for raising $5 billion in the market.”
Some banks have structured their repo transactions so that nothing needs to be rolled over on Aug. 2 or in the following weeks, one executive said.
Pacific Investment Management Co. Chief Executive Officer Mohamed A. El-Erian said the most critical indicators of distress will come from the markets.
“That’s the very first thing I do now is I go over to our money market desk and ask them, ‘What you are seeing today? How’s the repo market operating?’” El-Erian said in a radio interview on “Bloomberg Surveillance” with Tom Keene. “Because that is what can really trip an economy. So far it’s functioning OK, but we’re seeing some pressure.”
El-Erian said there would be “massive consequences” if the U.S. loses its AAA credit rating. Pimco, the world’s biggest manager of bond funds, expects the debt ceiling to be lifted, he said.
Banks have called meetings of their asset-liability committees, which govern the use of the balance sheet and interest-rate risk, and run internal stress tests under default or downgrade scenarios, according to one of the executives. Some lenders haven’t gotten answers to questions for guidance posed to the Treasury Department and Federal Reserve, another executive said.
“We have been engaged in operational planning with the Treasury,” Fed spokeswoman Barbara Hagenbaugh said. “We expect to be able to give additional guidance to financial institutions when there is greater clarity from the Congress and when Treasury outlines its specific operational plans.”
Money-market funds are also preparing by increasing their liquidity, JPMorgan’s Belton said. Prime money-market funds currently have 40 percent of their assets in securities with less than a week to maturity, up from about 32 percent a month ago, he said.
“Over the last month both in government money funds and prime, they are shortening the tenor of the assets they’re holding,” Belton said.
Treasury Secretary Timothy F. Geithner has said the U.S., which reached its borrowing limit on May 16, will exhaust measures used since then to avoid breaching its $14.3 trillion debt threshold on Aug. 2. The Treasury Department may have cash to delay that deadline for days or even weeks because of higher tax revenue, according to analysts at UBS AG and Barclays Capital.
If there’s panic and Treasury prices decline, banks may face unrealized losses in their securities portfolio, where many of the largest U.S. lenders hold Treasuries and debt issued by government-sponsored entities such as Fannie Mae. Commercial banks’ total holdings of Treasuries and agency mortgage-backed securities were $1.67 trillion as of July 13, Fed data show, up from $1.11 trillion at the start of 2008.
A U.S. credit-rating cut would likely push up the nation’s borrowing costs by increasing Treasury yields by 60 to 70 basis points over the “medium term,” Belton said. That could increase U.S. borrowing costs by $100 billion a year, he said, estimating that the short-term yield increase would likely be about 5 to 10 basis points.
A 25 basis-point rise wouldn’t erode bank capital enough to be a concern, one of the executives said.
There have been some signs of investor concern. The Treasury yield curve has steepened this month with the difference between the yield on the 30-year Treasury bond and the 10-year note hitting 1.38 percentage points last week, the largest spread since November.
Easing concerns for U.S. banks is that they aren’t likely to be forced sellers of Treasuries on a downgrade since capital and risk-weighting rules aren’t tied to ratings, Citigroup Inc. (C) analysts led by Amitabh Arora wrote in a July 22 research note. The Bank Holding Company Act allows banks to hold Treasuries and agencies without limit, said two of the executives.
A downgrade to single-A could push some institutions to sell Treasuries, though that’s “extremely unlikely” unless the U.S. government suffers a technical default, Arora wrote.
“Given how the market has reacted, I think you have to conclude that most investors see this debt ceiling situation as an opportunity,” GoldenTree’s Wagner said.