I attended the Federal Reserve’s conference on “Fire Sales as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets” on Friday, October 4, 2013. I want to share the proposals out there about the fire-sale issue. There were three formal proposals presented, one additional suggestion by a panel speaker, and then I added my own personal proposal at the end of this article.
First off, let’s be clear, the Fed specifically does not advocate any solution that was presented. Additional, I won’t go into the basics of Tri-Party Repo reform and “fire-sales,” I did that a few months ago in Tri-Party Reform Then And Now. However, I will start with the Fed’s definition of a fire-sale. It’s when an entity is forced to sell quickly and at a low price. The key part here is that others must be harmed by the “fire-sale;” other market participants who were not part of the original Repo transaction. As one official noted, “We don’t care if people run, as long as it’s not systemic.”
1. New Regulation
Remember the Bill Dudley (President of the New York Fed) speech last February? He said pretty clearly that if market participants don’t reform the Repo market and address fire-sale risk, the Fed will do it through new regulation. They certainly haven’t been sitting on their thumbs the past eight months. First, let’s note is that current regulation (Dodd-Frank, Basel III) was not designed to address fire-sales. It just wasn’t on the radar of top government officials at the time. Even if it was, leverage ratios and increased capital requirements would only address fire-sales and Repo reform indirectly. Instead of targeting banks overall, it’s better to look one level down and target the matched-book businesses themselves. Go straight to the source – reform the Repo businesses within the banks instead of the banks overall.
Therefore, new regulation could mean a leverage ratio specific for Repo matched-books, or perhaps a capital charge for the larger bank matched-books. I was surprised to hear that they already have a name for it, “Net Stable Funding Ratio.” Perhaps it’s further along than we expected. It doesn’t end here, there’s still another possibility.
Suppose you drill down one level further and target the securities themselves with “universal margin requirements.” As it turns out, this is the solution that academics like the most. Deal with the problem on the securities level. That means financing haircuts would be larger than they are now. In a way, it’s still like a leverage ratio and/or capital charge. Larger haircuts mean the securities owners must put up more capital to be in the business. Less leverage and more capital makes the system more stable, but it still doesn’t necessarily solve the fire-sale issue. If someone goes down, even with more Repo regulation, the liquidation issue is still out there.
2. Repo Resolution Authority
Another speaker proposed a market sponsored liquidation facility. I’ve heard this type of idea floated around before. It’s based on an industry sponsored facility that takes over a failing entity’s positions and liquidates them. At first glance, it sounds pretty good. In one way, it’s a throwback to the clearinghouses of yesteryear (See my History of Central Clearing Counterparties), so there’s a historical background and a good precedent. It was a good system before the Federal Reserve was established in 1913, but the clearinghouse liquidation function became obsolete once the banking system had a “lender of the last resort” in the Fed.
Many proponents of this idea use Long Term Capital Management as a showcase. When LTCM was failing, their counterparties (who were holding many of the same trades as LTCM) pooled their funds together, took over LTCM, and unwound their positions over time at a pace which did not stress the market. In the LTCM case, it was successful.
However, in order to institutionalize such an authority, there are a couple of major problems. The Repo market’s exemption from the automatic stay provision of the bankruptcy code (see my market commentary on Two Bankruptcies That Created The Modern Repo Market) would have to be changed. That’s a big problem. One of the main pillars of the Repo market is that the non-defaulting entity has immediate liquidation rights. Imaging waiting weeks or months to get your cash or securities back? The Repo market would mostly go away. From a practical standpoint, any solution that requires changes in the bankruptcy status of Repo is a non-starter.
Then, one questioner asked, “Where does the capital come from?” The answer was that all market participants would be required to contribute. A couple hundred million dollars is one thing, but what if Bear Stearns went bust with $30 billion in illiquid securities. Where would the authority get that kind of money? Obviously, they need funding from the Fed.
3. Remove The Tri-Party Function From The Clearing Bank
The third approach was to target the infrastructure of the Tri-Party system, the “plumbing. There are two main Tri-Party clearing banks. There used to be more clearing banks, but they disappeared through consolidation and mergers. Right now, in fact, one bank accounts for about 80% of clearing activity. The premise is that clearing has a competitive advantage with larger scale and the market is moving toward a monopoly structure anyway. Remember AT&T? As the nationwide phone system was being created, the efficiencies offered by a monopoly served as a more competitive structure. A national telephone utility was a more efficient business model, at least until it wasn’t and then it was broken up.
The idea here is to remove the Tri-Party function from the clearing bank and create a utility within a special purpose entity. It would have state-of-the-art technology and access to back-up liquidity from the Fed.
One immediate benefit removes the conflicts of interest from “complex” clearing banks. Remember JP Morgan and Lehman, then there was JP Morgan and MF Global. Obviously you see the pattern.
Now, I’m a free market thinker, so I believe that having more clearing banks and fostering more competition is a better solution, in principle. A more open system with more competition is always going to be better than a government run monopoly. I also wondered that when such a clearing utility was yanked out of the main clearing bank, would the broken up entities be nicknamed “the baby-BONYs”?
4. Investment Advisors
There was another proposal informally put forth by a panel member. He suggested that the liquidation function be given to an elite group of large investment banks. Since they have the risk management skills and experience with liquidations, they’re the best equipped to handle the situation. That the market is better off in a liquidation with a third party involved. In fact, this system is already used by central clearing counterparties. Oh, and as it happens, this person’s investment bank happens to run a large business in the space.
5. The “Open Access Liquidity Program” – My Solution
Where the other solutions took about 45 minutes present and explain, my solution is pretty easy and can be done in about 10 minutes. I’ll start off with a hint: both the Repo Resolution Authority and clearing utility have one thing in common, they’re camouflage for access to the Fed’s “lender of last resort.”
In order to devise a solution, it’s best to go back and look at the real problem. Back in 2007, investment funds were over-leveraged and lost liquidity, including Bear Stearns Asset Management, BNP Paribas funds, Sentinel Capital Management, and the Carlyle funds. Then, in 2008, banks and investment banks were over-leveraged and lost liquidity. The original intent of TARP was to buy distressed assets. That’s where the system was clogged. There were too many bad assets and no one to buy them. Right after TARP was passed, it was realized that buying distressed assets was too complicated and would take too long. Instead, TARP funds were used to buy preferred equity stakes in the distressed banks.
Going back to the original intent of TARP was government provided liquidity, that is, back-up funding. Basically, a “lender of last resort.” Wait, that’s something the Fed is supposed to do anyway. It’s one of the founding principles of central banking. Well, the banking system has changed a lot in the past 100 years. Banking functions are performed by non-banks, the “shadow banks.” So here’s the problem: there is back-up liquidity support for traditional banking, but not for shadow banking. Central bank liquidity did not evolve with the changes in the banking system, it remained static.
That’s the problem today: money funds, broker-dealers, FCMs, asset-backed conduits, hedge funds, etc. don’t have access to back-up funding from the Fed.
Here’s the solution. The Fed has a large QE portfolio of Treasurys, Agencys and Agency MBS. The market needs a Fed liquidity program to convert illiquid securities into liquid securities at times of stress. The Fed would expand its list of counterparties even further; much more than the 139 used for Reverse-Repo operations. The new Fed liquidity program would be like the securities lending program, but instead take illiquid securities in exchange for liquid ones. There would be different classes of securities with different haircuts and spreads. For example, the Fed might swap AA-rated CMBS for Treasurys at a fixed spread of 200 bps with a 35% haircut. The basis point spread and haircut must be punitive, given the facility is not supposed to be a day-to-day source of funding for anyone. It’s only for times of crisis.
The “Open Access Liquidity Program” would give all financial institutions access to liquidity. The Fed becomes the “lender of last resort” for the whole banking system. Let’s just say the Fed’s role is updated to meet the needs of the modern banking system. During a time of crisis, this funding program will give an institution time to wind down because they have access to funding. It means fire-sales are less likely when the institution can be unwound over a longer period of time. The program preserves value in the economy because the other businesses within the institution are not wrecked, they continue to function. Picture all the good businesses that were wrecked from the illiquid real-estate holdings of Lehman Brothers. Suppose the “Open Access Liquidity Program” was alive in March of 2008. Back then, Bear Stearns could not fund their CMBS, RMBS, or other private-label securities. They were solvent but not liquid. With the program I propose, Bear could have continued had they been able to swap their distressed securities at the Fed for Treasurys.