Unstable Repos and the London Connection

I ran across a great article by Jeffrey P. Snider that was not posted to Talkmarkets. He has many astute articles regarding Fed behavior posted here at Talkmarkets and people should read them anytime they have the opportunity to do so. But this article posted elsewhere was certainly an eye opener to me. It has to do with a subject he often covers on our website, repo fails.

I want to first mention that at the end of this article we can see what this disturbing wholesale financial market is doing to the world economy, and we can see that most of this trading is done in the Square Mile, as London is the seat of world finance.*

Repo fails result from counterparties failing to deliver US treasury bonds for a deal. Often, the counterparties see treasury bonds of various maturities being more valuable than the cash they would get in the loan they request. When the bonds are special, they are in massive demand. They are hoarded. When the repo failures reached a peak, in the liquidation of the economy in 2008, Mr. Snider stated this concerning that time period:


Obviously that means in these times that, at the margins, collateral is more "valuable" than cash. Where that imbalance is greatest you find a rush or surge in "fails", meaning a great number of counterparties decide they will at the end of the repo just keep the security rather than take back the cash that was lent.The worst of those was in early October 2008 and the repo stats from that time are unbelievable. The New York Fed estimates that in the last week of September 2008 total fails among primary dealer inventories were $3.5 trillion (combining both "to receive" and "to deliver"), up from $577 billion the week before when Lehman first failed. By the week of October 15, total fails hit $5.3 trillion and stayed at that level again the following week. The S&P 500 lost 32% during these weeks where repo fails surged. 
 What then happened, as he goes on to say, is that a 3% fail penalty was placed upon those who failed to deliver the collateral. That calmed things down. However, in 2016 fails ballooned again. Mr. Snider says: 
For the week of March 9, 2016, the New York Fed reports dealer fails of $889 billion, by far the highest since 2008 and greater than at any point during the 2011 crisis. This was not a surprise, however, as repo specials proliferated throughout several maturities with trading close to and even slightly below the calculated fails penalty (it's not a strictly 3% rate, it is a calculation related to federal funds). The following week, the actual week of the government funding auction, fails held high again at $873 billion. The middle of March is a seasonally strong part of the auction calendar, so clearly OTR to OFR was in that dreaded "dead spot" of transition but this was way, way out of those proportions.
Two authors writing for the New York Fed weighed in on the fails of March, 2016, stating that they amounted to 95 billion dollars per each day of the month, not reaching the levels of over 500 billion dollars per day at the peak in 2008 and explained it this way:

 The spike in fails is primarily attributable to a jump in fails of benchmark (that is, “on-the-run”) securities but also to a continued rise in fails of seasoned securities, or securities issued more than 180 days prior. Both series reached post-crisis highs in March, with aggregate benchmark fails averaging $36 billion per day and aggregate seasoned fails averaging $50 billion per day. Fails in all other (or “lightly seasoned”) Treasury securities were below post-crisis highs in March, averaging $9 billion per day. 
Limited supply of long bonds resulted in a shortage of bonds needed to cover short positions. By the way, the bond market is massively shorted at this very time. Look for the possibility of serious need for collateral in the future. Keep in mind that the New York Fed does not necessarily back what its authors say. That is quite annoying, in my opinion. The authors, Michael Flemming and Frank Keane, go on to say:

 That is, aversion to the counterparty credit risk that would ensue from not having securities promptly returned may cause some owners to choose not to lend when specials rates approach the fails rate, despite the high compensation provided to securities lenders at such times. Such a pullback can increase the likelihood that settlement fails will persist as reductions in available supply exacerbate the market imbalance. 
Insufficient incentive to borrow securities to avoid failing contributed to episodes of high and persistent settlement fails after September 11, 2001in the summer of 2003, and during the financial crisis. Record fails during the crisis provided the impetus for the Treasury Market Practices Group to promote the introduction of a fails charge in May 2009, as explained here. While the charge did not eliminate settlement fails, fails have been lower since, with fails episodes being of lesser magnitude and duration. 
The question is, since the Salomon Brothers bond hoarding scandal of the early 1990's, are dealers and/or counterparties trying to corner the market on bonds, then being able to make massive profits on them by selling them at a high price?  Bloomberg weighs in:

“The Fed doesn’t own a lot of the on-the-run issues,” said Guy Haselmann, head of capital-markets strategy in New York at Bank of Nova Scotia, a primary dealer. “Usually when there is something that is super special, or there is a problem, the Fed can lend them and ease it. What can also kind of cause a squeeze in repo is that there is a real-money, end-user buyer that just doesn’t lend them out.”
The strains in repos are fueling speculation the Treasury Department will request information on large holders of the note, as it’s done in the past when there were shortages. Treasury has conducted 14 calls for large positions since the reporting program took effect in the 1990s in the aftermath of the Salomon Brothers bond-market scandal. The aim is to guard against market manipulation, such as efforts to corner the supply of a security to drive up the cost of closing short positions.
 The truth of the matter, according to Jeffrey P. Snider was that primary dealers were in on the bond hoarding as well.  

Mr. Snider goes on to say that this is a broken system, and is not reflective of true capitalism. He says in closing:

 As noted before, the Office of Comptroller of the Currency had by 1956 seen enough of this in practice of repos to completely reinvent their statutory treatment - to see them as collateralized money market lending as surely they were becoming. The fact that OCC reversed its ruling eight years later only suggests that banks had complained effectively enough in political terms to allow them to turn repos into what is now standard global practice.
 True money operates as property under property law; eurodollars, repos, and other wholesale monetary deliveries operate exclusively under financial law far more malleable and flexible.
This financialism of money, as Mr. Snider explains, is proof the real economy has not recovered. As Wikipedia says, it shows that profits are to be made through financial vehicles, structured finance if you will, rather than through what happens in the real economy.  Repo fails are potentially an economic indicator of really bad times, as they were in 2008. 

*The center of all this structured finance is not Wall Street. It is the Square Mile. That is the seat of high finance in the world. Do not be fooled about that. The article at Wikipedia provides this insight:

Contrary to common belief in the United States, the largest financial center for derivatives (and for foreign exchange) is London. According to According to MarketWatch on December 7, 2006, 
The global foreign exchange market, easily the largest financial market, is dominated by London. More than half of the trades in the derivatives market are handled in London, which straddles the time zones between Asia and the U.S. And the trading rooms in the Square Mile, as the City of London financial district is known, are responsible for almost three-quarters of the trades in the secondary fixed-income markets.
It is true that this financial center, London, proves that even today, the sun never sets on the British Empire.  Perhaps that is why our Fed treats Americans with such disdain in their procyclical liquidation behavior when downturns occur, while the Bank of England does no such thing to citizens of Great Britain. 


This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/global-markets/unstable-repos-and-the-london-connection?post=121987&uid=4798





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