Repos, or repurchase agreements, are a key source of short-term financing for Wall Street banks and other financial institutions, and they are under scrutiny once again for being fraught with risk. A Fitch Ratings report in August found a significant weak point in repo markets, a part of the “shadow banking” system that finances trillions of dollars in banks’ trading activities.
The repo market is “an important utility in the financial system and promotes liquidity,” says Martin Hansen, senior director of macro credit research at Fitch Ratings. The problem with the repo market currently, though, is the quality of the collateral that Wall Street banks and other financial institutions are using to borrow this short-term cash, says Fitch.
In general, repos are used to buy and sell groups of securities, traditionally Treasury bonds and other government-agency instruments, in short-term transactions, usually overnight. The securities are put up as collateral by a borrower, typically a Wall Street bank, and in exchange the borrower receives cash from counterparties that charge interest.
But instead of using Treasuries and other government-backed instruments, banks are funding repo borrowing with structured-finance securities — less-liquid, more-volatile assets. In a stressed market, that could create significant liquidity risks for repo borrowers and underlying assets, says Fitch.
If repo lenders like money-market funds (themselves highly subject to market stresses) suddenly refuse to finance this riskier collateral, that would result in a liquidity shortage for borrowing banks. The banks could then be forced to dump the securities in a fire sale that would drive down prices or even make the securities unsellable.
While Treasury and agency securities still fuel a majority of repo lending, about 35% of the repo market was financed by riskier securities as of February 2012, according to Fitch. In Fitch’s sample, 43% of the structured-finance, or asset-backed, securities financed were legacy subprime and Alt-A home loans.