Fire Sales Risk Requires Repo Market Reform, N.Y. Fed Paper Says
The over $2 trillion-a-day repurchase agreement market requires changes to cut risks related to sales of assets triggered by a dealer default or lenders’ perceptions that it may, according to the Federal Reserve Bank of New York.
The potential for so-called “fire sales,” or rapid selling of assets at reduced prices, remains a source of financial instability, New York Fed economists Brian Begalle, Antoine Martin, James McAndrews and Susan McLaughlin wrote in a paper posted today on the bank’s website. Since the 2008 financial crisis that caused a near global credit freeze and disruptions in repo funding, global policy maker have sought to increase bank capital and mitigate side-effects of bank defaults to prevent the need for future government bailouts.
“Limited tools are available to mitigate the risk of pre- default fire sales and no established tools currently exist to mitigate risk of post-default sales,” Begalle, Martin, McAndrews and McLaughlin wrote. “The risk of post-default fire sales in the tri-party repo market cannot be eliminated altogether,” unless before such an event there is a “mechanism that provides for the orderly liquidation of tri-party collateral.”
The Fed has been seeking to strengthen the tri-party repurchase agreement market, which near collapsed in 2008 amid the demise of Bear Stearns Cos. and bankruptcy of Lehman Brothers Holdings Inc. during the financial crisis. The central bank took over efforts to improve functioning of the market for in 2012 after the private-sector Tri-Party Repo Infrastructure Reform Task Force, sponsored by the Fed in 2009, disbanded.
The Fed created liquidity facilities to prevent fire sales and support its primary dealers in 2008. The central bank backstopped the market through the Term Securities Lending Facility, for loans of Treasuries to Wall Street dealers, and the Primary Dealer Credit Facility for cash loans to the firms.
“The resiliency of dealers could be enhanced by reducing their reliance of short-term funding, or through additional capital and liquidity regulation,” the Fed staffers wrote. The risk of dealer pre-default asset sales is heightened by the practice of maturity transformation, when repos have a shorter maturity than the securities that serve as collateral, as well as liquidity transformation, the report said.
While, the risk of post default sales, from money market mutual funds and other counterparties that hold the securities used as collateral for the repos, is primary because such transactions are exempt from a bankruptcy regulation that typically prevents creditors from immediately taking possession of assets. These investors would likely quickly sell the securities, according to the Fed report.
Repos are transactions used by the Fed’s primary dealers for short-term funding and typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, typically a money-market mutual fund.
In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. (JPM) and Bank of New York Mellon Corp. (BK) serve as the industry’s clearing banks.
“The risk of fire sales would be mitigated if the assets serving as repo collateral were sold by an institution, or a set of institutions, that has incentives and the ability to maximize the value of these assets,” the Fed economists wrote. “It could be the clearing bank of the defaulting dealer, a large asset manager, or a consortium of asset managers, a dealer, or a consortium of dealers, or a special-purpose entity created specifically for that role.”
A so-called resolution authority for the repo market, to orderly liquidate repurchase agreements and prevent fire sales of underlying assets during periods of financial stress, was proposed as a way to reduce risks in March 2012 by New York University Stern School of Business professors Viral Acharya and T. Sabri Oncu in a paper presented at a Federal Reserve conference in Washington.
Laws and regulations including Dodd-Frank Act and Basel III are focused on systemically important financial companies. What has yet to be fully addressed is systemic risks associated with certain assets and liabilities, such as repurchase agreements, Acharya and Oncu wrote in the report.
‘In the absence of a mechanism or process for ensuring that private-market participants have proper incentives to engage in orderly liquidations of assets as needed, the official sector will likely have to resort to emergency measures in order to limit the disruptions to the financial system that fire sales would create,” the Fed economists wrote.
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