One Trillion Reasons Shrinking Repo Markets Should Vex Taxpayers

  • Regulatory reaction to financial crisis crimps funds' leverage
  • Public pensions rely on outsize returns to plug deficits

Taxpayers on the hook for public-pension costs may end up footing more of the bill because of regulatory efforts to make the financial system safer, according to analyst Zoltan Pozsar at Credit Suisse Group AG.

Rules enacted after the credit crunch have shrunk the amount of funding banks can offer asset managers seeking leverage in the market for short-term loans known as repurchase agreements, or repos. That poses a problem for governments and nonprofits that depend on the investment firms to manage their pension funds and endowments, Pozsar said Monday at the Bloomberg Investment Strategies Forum.

By Pozsar’s reasoning, the move has constrained money managers’ ability to enhance returns with money borrowed through short-term agreements with banks. The size of the tri-party repo market has dropped about 20 percent since December 2012, according to Federal Reserve Bank of New York data. That adds to the challenge for the investment firms’ clients -- including the U.S. public pension funds facing a combined $1 trillion deficit.

“Question number one should be, ‘What are all these investment strategies going to be replaced with?”’ Pozsar asked in a panel at the forum in New York.

Tough Environment

It’s already a tough environment for many investors, with bond yields near record lows. In the U.S., states and localities rely on the money managers to bridge the $1 trillion gap between the governments’ pension assets and what they’ve promised to workers.

The risk is they’ll fail to meet annual return assumptions, which average about 7.6 percent in the U.S, according to the National Association of State Retirement Administrators. Pension funds such as the Teacher Retirement System of Texas have responded by using strategies that try to spread risk equally among asset classes. In some cases, that involves levering up less risky fixed-income investments.

Luxury Lament

While the transition may be tough for investors who were accustomed to the balance-sheet access that Wall Street used to provide, it has made the financial system more resilient, Pozsar said.

“The analogy there is, you can have a world where everybody is going to get their suit tailored at Zegna and that looks beautiful, or everybody’s going to buy a suit at Men’s Wearhouse,” he said. “It’s off a bit here, and it’s off a bit there, but it still gets the job done.”

As a result, some money managers may push even further out on the spectrum of risky assets. Pension funds in some countries have boosted holdings of less liquid, alternative assets such as real estate, infrastructure and private equity since the financial crisis.

Investors may just need to get used to lower returns, according to Andrew Sheets, Morgan Stanley’s chief cross-asset strategist.

As the Fed tightens monetary policy, investors won’t get as much extra return for the additional risk they take on, Sheets said in a note. That is, the efficient frontier -- the combination of stocks, bonds, and other assets that results in the best risk-adjusted return -- is moving downward.

So, global regulators have essentially made it tougher for investors to earn returns, Pozsar said. That means taxpayers may get stuck with some of the bill.

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