Looks like there’s a storm brewing in the U.S. repo markets.
It figures: profit-center banks have every motivation to stay one step ahead of the regs and the pols. Since the gamekeepers have now gotten around to looking at proprietary trading and bringing derivatives onto exchanges, you can almost bet your first-born that the next crisis will be in neither one of these areas but someplace else entirely different.
As Walter Kurtz describes so well on his Sober Look blog (emphasis added):
Tremendous leverage is in fact available via repo, a market far larger than CDS. The media often misses the fact that MF Global failed because of repo based leverage. And by the way so did Lehman and Bear Stearns and Merrill Lynch – all failed because they could not roll their repo loans. That’s why repo markets are of critical importance to the financial system and need to be well understood by policy makers. It’s amazing that a typical US politician knows more about the Kandahar Province in Afghanistan than what a repo transaction is.
On the most basic terms, a repo is a short-term collateralized loan. The borrowers are the big banks and broker dealers: JPMorgan Chase, Bank of America, Citigroup and others. They’ve got fixed income securities on hand (some theirs, some belonging to their clients.) They post these bonds to the lenders, who are usually mutual or money market funds, other asset managers and custodial banks.
The lenders provide cash in varying proportions to the collateral posted. If it’s a super-safe, super-dull bond like a U.S. Treasury then they’ll get close to one dollar in cash for every dollar’s worth of bonds that they offer up. If it’s a riskier bond then they’ll get far less. And if the bond goes down in value or gets downgraded by a ratings agency while the loan is still outstanding, then the lender will usually make the borrower post more collateral to reflect that increased risk. At the end of the agreed-upon term the lender gets its cash back, the borrower gets its securities back and all’s square.
If the collateral underlying a repo deteriorates, the lender calls for more security, and the borrower can’t provide it, then you could be looking at the start of a Lehman death spiral. These borrowers do everything in size, so it’s likely that they would have been using that same type of collateral all over town. They wouldn’t have just one lender hounding them to post more collateral, they’d have several. Even other kinds of counterparties who’ve got nothing to do with these trades might hear about it and start pulling back credit. And then the repo lenders themselves may become unable to honor their own obligations because of their exposure to the deadbeat borrowers. And so on, like a domino trail. Cue the apocalypse.
Now the lending funds who this brush with death were understandably gun-shy in the immediate aftermath of the crisis and, for a while, resolved to forego juicier returns and to stick to accepting only the safest, most highly rated stuff as collateral. But that’s now starting to change.
A report by Fitch Ratings says that the use of lower-rated debt in repos has returned to “pre-crisis” levels. And, by the way, they’re back to using bonds backed by subprime and low-quality residential mortgages. The U.S. repo market is worth around $1.6 trillion; Fitch looked at data from 10 of the biggest money market funds engaged in repos and found that 20% of the underpinning collateral consisted of structured finance, or repackaged loans, and that almost half of this is made up of repackaged subprime and subprime-like mortgages.
The ratings agencies have admitted their earlier “mistakes” of rating these risky mortgage-backed bonds too highly. And since the crisis, they’ve adjusted their models, rerun their analyses and let the downgrades fly. All the negatives are already priced in, right?
Not quite. Naked Capitalism hipped us to a face-palm-inducing report from R&R Capital from just a few weeks ago:
Realized losses declared on private residential mortgage-backed securities (RMBS), already much higher than original rating agency and investor estimates, are projected to rise substantially in the coming months […].
On the securities performing at December 2011, a universe of approximately $1.42 trillion, R&R estimate the amount of additional losses likely to materialize is $300 billion, with one-third concentrated in ten arranger names, including Countrywide, Morgan Stanley and JP Morgan. About 17,000 tranches, or 34% of the universe analyzed by R&R, may lose up to 83% of their remaining principal.
In addition, R&R estimates that approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. Failure to allocate realized loan losses could distort the valuation of related RMBS tranches.
This is not to mention the fact that the features of the Obama administration’s ever-changing homeownership help programs are getting closer and closer to inflicting pain on RMBS investors. As Yves Smith says (emphasis mine):
[RMBS] investors have sat on the sidelines during the mortgage settlement and “fix the housing market” debates, even as becomes clearer and clearer that the solution envisaged is to take from investors to make the banks whole.
What happens when the eventual losses start being reflected as lower valuations and dropped ratings for the RMBS collateral being used in the repo market? Who’s going to get hosed here? And where will this latest domino trail lead?