Fire Sale Risk Climbs With Equity-Backed Repo Rise, Fitch Says

Increased use of equities collateral in the U.S. market for borrowing and lending securities may heighten regulators focus on the risks of rapid asset sales disrupting financial markets, according to Fitch Ratings.

Repurchase agreements, known as repos, backed by equities rose 40 percent during the year ended Jan. 10, according to Federal Reserve data. Rising equity-collateral usage combined with a slide in repos backed by government securities pushed equities share to 9.6 percent of the $1.55 trillion tri-party repo market in January, up from 5.7 percent a year earlier, Fitch said in a report published yesterday.

Fed policy makers and researchers have discussed during the past year that the repo market still requires changes to reduce risks related to fire-sales triggered by a dealer default or lenders’ perceptions that it may default. 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 government bailouts.

“One reason for the equity-backed repo increase is because of the higher yield available on them, that is, from the lenders perspective,” Robert Grossman, managing director of macro credit research at Fitch in New York said in a telephone interview yesterday. “All other things being equal, in a distressed market the nongovernment collateral can have more liquidity issues. One of the policy issues on the horizon is fire-sale risk.”

Repo Rates

Rates on short-term equity-backed repo transactions were 35 basis points, compared with about 11 basis points on agency repos, according to a separate Fitch study using August 2013 data.

Fed policy makers and researchers have discussed during the past year that the repo market still requires changes to reduce risks related to fire-sales triggered by a dealer default or lenders’ perceptions that it may default. 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 government bailouts.

The Fed has been seeking to strengthen the tri-party repurchase agreement market, which almost collapsed in 2008 amid the demise of Bear Stearns Cos. and bankruptcy of Lehman Brothers Holdings Inc. 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.

Even as U.S. share prices have surged since 2011, reaching record levels last month, “the degree of leverage achievable through repo borrowing for equity collateral is unchanged,” with median discounts holding stable at about 8 percent, according to the Fitch report. The discount refers to the percent difference between the value of a security used as collateral in a repo transaction and the amount of cash a lender is willing to exchange for it.

“This is something to watch,” Grossman said, noting that during the financial crisis equity discounts weren’t raised until after the market started to decline.

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