Awaiting the return of the repo market

--Two sources of short term funding market, interbank deposit and repo, have been in a disarray --Fed's liquidity programs, bond guarantee, rate cuts have ease the strains of these two markets. But the levels of the two markets remain elevated. --The lower fed rates might trigger the repo fails, which will disrupt interest rate swaps market. Awaiting the return of the repo market By Michael Mackenzie Published: December 16 2008 22:36 Last updated: December 16 2008 22:36 The collapse of investment banks this year highlighted the pivotal roles played by two critical sources of short-term funding that had long been taken for granted: the interbank deposit market and the government repurchase or “repo” market. Already stunned by the near-failure and rescue of Bear Stearns in March, investors abruptly exited short-term markets after the collapse of Lehman Brothers in September and the investment bank financing model came to a standstill. Lending in the interbank deposit market dried up, as money market funds shied away from providing banks with short-term loans after Lehman’s bankruptcy wiped out billions of dollars of its debt. Funds also pulled away from the commercial paper market, an important source of funding for companies. That breakdown prompted the Federal Reserve to step in: since the end of October the central bank has purchased more than $313bn in commercial paper alone. Series: Markets in crisis US public finance arena wilts under pressure The Fed has also implemented a number of liquidity programmes designed to help banks access funds rather than rely on the private interbank market. “The Fed is providing the market with a crutch into year-end,” says George Goncalves, strategist at Morgan Stanley. Mr Goncalves fully expects liquidity programmes to remain in place during 2009 and believes that forming an exit strategy from supporting the financial system will pose a challenge for central banks. The freeze in lending was best tracked by watching a surge in floating money market rates. At the daily fixing in London, the three-month dollar London Interbank Offered Rate rose to a peak of 4.82 per cent in October. Since then the Fed’s provision of liquidity and aggressive rate cuts has helped ease some of the strain in Libor. On Wednesday, Libor is expected to set at 1.65 per cent. Strong demand for recently issued bank debt that is backed by the Federal Deposit Insurance Corp has also helped ease funding strains. However, Libor still remains elevated when compared with Fed funds, which now trades in a range between zero per cent and 0.25 per cent. With official overnight interest rates so low, problems remain for the other important source of bank funding. Fear of lending securities in exchange for a short-term cash loan dominated the repurchase market. Over the past decade, many banks became dependent on repo, whereby they lend out assets such as Treasuries, mortgages and other bonds in return for cash. This type of financing helped bring down Bear as investors lost confidence over lending cash in return for Bear pledging mortgages as collateral. Lehman’s bankruptcy left investors questioning the creditworthiness of all banks and the repo market hit the wall. While lending for overnight continues, term repo – anything with a lifespan of more than one day – remains impaired. “Repo will find its way back into the market as an important tool for financing and liquidity,” says Art Certosimo, executive vice-president at Bank of New York Mellon. “Right now we are still in fear mode, but as capital markets start to [return to] some normalcy again, institutions will start taking risk for reasonable reward.” The breakdown in the repo market also unsettled the trading of interest rate swaps as dealers often hedge the derivative with government paper. The cost of financing that note in the repo market helps influence where swaps trade relative to a Treasury yield. That came as heightened volatility in daily Libor settings made it extremely difficult to trade a swap, which involves exchanging two cash flows. One flow is a fixed rate that is priced off Treasury yields, while the floating rate references three-month Libor. The problems in the repo market peaked in October when failed trades rose to a record. A repo “fail” occurs when a security that was previously borrowed is not returned on time. Given the entrenched links between dealers and investors, once a security fails, it can ripple along a long chain and shut down the repo market, which ended up happening in the aftermath of the Lehman bankruptcy. Although repo fails have been cleaned up, the repo market faces renewed problems as the Fed’s infusion of liquidity has lowered the effective funds rate to nearly zero per cent. This type of interest rate environment negates the profit from lending out a Treasury security in exchange for a short-term cash loan. Michael Cloherty, strategist at Banc of America Securities says: “With rates this low, there is little incentive for securities holders to lend their supply and we are likely to see fails start rising again.” Early in January the repo market will likely implement some new rules that were recently proposed by the Treasury Market Practices Group. The new recommendations have been endorsed by the Fed. The primary goal is to alleviate repo fails by introducing a penalty rate for dealing with failed securities. That will enable a security to trade at a negative level capped at 3 per cent below the current target funds rate. As the repo market struggles to adjust to a new regime of low and negative interest rates, and investors wait for signs that money market funds have started trusting banks again, there is no certainty that the worst is past. “The wild card is another shock to the system. However, central banks are providing plenty of support for the financial system,” says Mr Certosimo. This article is the first in a series