Recently, there has been a great deal written about what ails the U.S. repo markets. The issue centers on the liquidity problems that were exposed in mid-September, when overnight funding rates for government securities went from 2.24% to a peak of 10% in a day, and then stayed unusually elevated until the fed intervened. The scale of this issue is akin to the “Flash Crashes” that occasionally pop up in other financial markets, but the repo market regularly suffers from “mini” Flash Crashes, pointing to a more fundamental problem in the market, requiring ongoing frequent intervention by the Fed to maintain normal market rates.
The September rate spike was driven, in large part, by a sudden reduction in cash available to fund financial assets, like government bonds. The reduction was not driven by economic, credit, or financial concerns; rather, it was a confluence of events that pulled money out of the repo system as it was needed for other purposes, including corporate tax payments. Events like this are not unusual, and are generally predictable, in the repo markets; for example, rates normally spike at year-end as cash availability dries up. These spikes have gotten worse due to important structural changes that have occurred in the financial system post-Credit Crisis that have diminished the risk-absorbing capacity of banks, broker/dealers, and money market funds, the main players in the repo ecosystem. The question is, why don’t other institutional investors step into this market when these opportunities arise?
The major roadblock to broadening participation in this market harkens back to one of the last unresolved issues pre-dating the Credit Crisis: the process by which the key credit rating agencies rate repurchase agreements and money market funds. In a nutshell, the rating agencies tend to rate a repurchase agreement solely based on the counterparty being funded. As long as the counterparty is investment grade, the rating agency will generally give a money market fund a “AAAmf” rating, the highest rating available for a mutual fund. This is critical, because the investment guidelines of most institutional investors that buy a money market fund requires that the fund be AAAmf, and these money market funds are the main providers of funding for the banks and broker/dealers that fund in the repo markets.
For the rating agencies to hang their hats on just the repo counterparty is odd for two reasons: first, the collateral backing the repo – typically government bonds – usually have a higher rating than any repo counterparty. Second, and more importantly, repos are secured with marketable securities with a current value greater than the cash advanced on the repo (defined as “overcollateralization”). If this overcollateralization provides the lender with sufficient protection relative to the risk of the securities declining in value, the risk of loss is limited.
Think of this from the viewpoint of the collateral: assume a money market fund has a repo with an unrated counterparty collateralized with 1-month T-bills with 2% over-collateralization. For a one-month T-bill to decline by 2 points equates to market yields increasing from 1.55% to almost 27% overnight, an unprecedented increase. Statistically (and historically) speaking, it is more likely that an investment grade counterparty collapses suddenly (as several did in 2008) than for interest rates to increase by this amount overnight. Perhaps picking the right collateral and amount of over-collateralization is just as important as picking the borrower.
What’s needed is to have the rating agencies produce repo ratings based on quantitative, dynamic risk measures instead of the current framework that relies exclusively on counterparty rating. In other words, this is not a “get rid of the rating agencies article”; our suggestion is that they simply up their game a bit, and rate repos more dynamically by incorporating the risk mitigation capabilities of overcollateralization relative to the securities backing the repo.
These changes would allow more repos transactions to be rated, opening the doors to a wider swath of institutional investors able to provide cash into the repo markets. Repo would be evaluated in a reasonable risk/return continuum as an alternative to investing in securities; money managers would be asking questions like: “should I own the bond or finance it?” or “even if the borrower isn’t rated, is the repo overcollateralized enough to minimize risk?” or “for a given counterparty and collateral, what is the right level of over-collateralization? “ An entire new investable market would be created; we can call them “ultrashort financing” funds. These funds and pools of capital would be another part of the continuum of money market funds and short duration bond funds, but with the ability to own a greater array of the securities they fund in the case of counterparty defaults (as opposed to the limited universe money market funds can own) reducing the risk of forced selling, which we saw in 2008. Many of these short-term pools of capital have weekly or monthly redemption terms, as opposed to a money fund’s same day redemption terms. This allows an ultrashort financing fund to offer longer term financing than a money market fund, thereby improving the stability of the financing markets.
Without changes, the repo market will continue to rely on money market funds (“MMFs”). MMFs are used by investors like checking accounts, with large, destabilizing fluctuations in balances (as we saw in September) which exacerbate repo market volatility. Additionally, MMFs’ forced reliance on counterparty ratings severely diminishes their sources of borrowers, and the result is that they invest in repo at disadvantageous terms to these cash providers. We sometimes wonder how money market funds became the investment vehicle of choice for the repo markets.
Now is the time to re-visit this issue. With proper rating agency support and evaluation of repos, participation in the repo markets would be broadened, financing terms would be lengthened, and the risk of forced selling diminished. Repo should be a source of alpha for investors, not a source of agita.
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