19 May 2010

WSJ New York Fed pushes Wall Street on Repo overhaul

Officials at the Federal Reserve Bank of New York are pushing Wall Street firms to ramp up efforts to stabilize an important corner of the financial system called the repo market, where securities dealers attain trillions of dollars of short-term financing every day.

A working group of Wall Street firms on Monday recommended changes to this market that it said would make repo trading less prone to panics. But the New York Fed responded in a white paper that the proposed overhauls, while a step in the right direction, "do not address all areas of concern in the tri-party repo market," including the risk of fire sales of securities that could hurt the financial system.

 

It is a $1.7 trillion market, dominated by a few big banks and securities dealers, which had expanded to $2.8 trillion at the height of the credit boom and played a central role in the recent financial panic.

 

Wall Street firms get much of their short-term funding in this market, by putting up securities portfolios as collateral in exchange for cash from money-market mutual funds and other financial firms heavy with cash holdings. Two clearing banks, J.P. Morgan Chase & Co. and Bank of New York Mellon Corp., act as middlemen.

 

During the financial crisis, now-defunct firms like Bear Stearns Cos. and Lehman Brothers Holdings Inc. saw funding in these markets dry up.

 

One problem: Many repo trades unwind in the morning and resume at night, leaving the big clearing banks to act as lenders themselves during the day for a large portion of these trades. That exposure gives the clearing banks and other lenders an incentive to pull away quickly from firms if the firms get into danger. The task force proposed changes in the way the market operates, such as different settlement times, to remove the two banks from this role.

 

Stabilizing the repo market is one of 18 different projects that the New York Fed is running in response to the financial crisis.

 

The Fed said in its white paper that the proposed changes didn't address the propensity of cash lenders to run from troubled borrowers.

 

Fed officials also have been looking at how much firms are able to borrow against securities portfolios in repo trades. The more money they can borrow, the more leverage and risk is introduced to the financial system.

 

The task force called for stronger "margin" practices, which could force borrowers to put up more collateral for loans, but stopped short of recommending specific rules. Fed officials eventually could decide to seek their own margin requirements. One worry is that during booms, the rising value of securities has a tendency to induce more borrowing by firms, because the value of the collateral is increasing. And during busts the opposite happens. The combination can exacerbate booms and busts.

 

New York Fed President Bill Dudley has raised the idea of requiring more collateral, also known as larger haircuts, to weigh against firms adding to their leverage as asset prices rise. The Fed hasn't decided on such a measure, which likely would be opposed by the industry, but left open the possibility of more action.

 

"The FRBNY intends to take additional actions, as necessary, to promote the safety and soundness" of the financial system, the Fed said in the white paper.

 

The task force is led by Darryll Hendricks, of UBS Investment Bank, and includes people from Bank of New York, J.P. Morgan Chase, Bank of America Corp., Barclays Capital, Citigroup Inc., Credit Suisse Group, Morgan Stanley, Goldman Sachs Group Inc., Invesco Ltd., Fidelity Investments, State Street Corp. and other firms.

 

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