Recently, Zero Hedge presented a snapshot analysis of the various securities that made up the triparty repo agreement involving JPM, Lehman and the Fed. We uncovered numerous bankrupt companies' equities that were being pledged as collateral for what ultimately was taxpayer exposure. To our surprise, this discovery is not an exception, and in fact in the days immediately preceding the collapse of Bear Stearns first, and subsequently, Lehman Brothers, the Federal Reserve established and refined a program that permitted banks to pledge virtually any security as collateral, including not just investment grade bonds and higher ranked securities, but also stocks of companies, the riskiest investment possible, and a guaranteed way for taxpayer capital to evaporate in the context of a disintegrating financial system, all with the purpose of bailing out Wall Street's major institutions. On two occasions last year: on March 16, 2008, and subsequently on September 14, 2008, the Federal Reserve first established what is known as the Primary Dealer Credit Facility (PDCF), and subsequently amended it, so that the Fed, in becoming the lender of last resort, would allow any collateral, up to and including stocks, to be funded by the Federal Reserve's credit facility, in order to prevent the $4.5 trillion repo financing system from imploding. By doing so, the Federal Reserve effectively gave a Carte Blanche to primary dealers to purchase any and all equities they so desired, with such purchases immediately being funded by the US taxpayer, via the PDCF. In essence, this was equivalent to the Fed purchasing equities by itself through a Primary Dealer agent.
Readers who have been concerned with the moral hazard provided by the Fed's monetization of Treasury and Mortgage debt, should be doubly concerned by this Fed action which sent three key messages to Wall Street: i) it made sure that Primary Dealers would generate massive profits on risky assets as the Fed would provide the funding to acquire any and all stocks (keep in mind the cost of funding of the PDCF to primary dealers was negligible); ii) it tipped its hand as to the existence and modus operandi of the rumored "plunge protection team," iii) and it made clear that the much maligned, by none other than Chairman Bernanke, concept of "moral hazard" is the one and only systemically relevant doctrine as long as the Fed's Chairman is in control, and not subject to any auditing auspices. The fact that PDs used over $140 billion of taxpayer money within a few weeks of the program's expansion in September to fund what one can assume were exclusively equity purchases, demonstrates that the American financial system got the message.
The (Triparty) Repo System
Before we get into the details of the Fed's Primary Dealer Credit Facility, it is prudent to present the beating heart of the American financial system, more so than securitizations or money markets, all of which went into cardiac arrest on several occasions in 2008: the Triparty Repo system.
As the name implies, a triparty repo transaction involves three parties: a cash lender (the investor), a borrower that will provide collateral against the loan, and a triparty clearing bank. The triparty clearing bank provides cash and collateral custody accounts for parties to the repo deal and collateral management services. These services include ensuring that pledged collateral meets the cash lenders' requirements, pricing collateral, ensuring collateral sufficiency, and moving cash and collateral between the parties' accounts.
Both the investor and the borrower must have accounts at the clearing bank, and all three parties are bound by legal documentation called the triparty repo agreement. In the United States, there are two triparty clearing banks: the Bank of New York and J.P. Morgan Chase. One of the operational benefits of triparty repos is that, regardless of the term of the loan, the clearing bank unwinds the transaction each morning, returning the cash to the investor's account and the collateral to the borrower's account. Then at the end of the day, the borrower pledges qualifying collateral back to the deal, which once priced, determined as eligible, and deemed sufficient to meet the terms of the deal by the clearing bank, is moved to the investor's account while the cash is placed in the borrower's aaccount. In this way, no specific collateral is committed for more than overnight. This arrangement allows borrowers to pledge whatever eligible collateral they have on hand each day, thus enabling them to manage their securities portfolios more effectively.
An important implication of this daily unwinding, however, is that the counterparty risk for the investor shifts from its repo counterparty to the triparty clearing bank, and the clearing bank becomes exposed to the borrower. Overnight, the cash investor has the borrower's collateral in its account and the borrower has the cash. If the borrower defaults overnight— say, by filing for bankruptcy—the lender has the collateral in its account and thus is covered and the clearing bank is not affected. Once the collateral and cash are returned in the morning, however, the clearing bank, which has extended credit to the borrower to finance the original collateral purchase, becomes exposed to the borrower. Consequently, the clearing bank needs to determine each morning if it is comfortable accepting the exposure to the borrower that the reversal of the transaction will create.
As readers will recall, the reason why Jamie Dimon blew up in his letter to Barclay's John Varley and in fact threatened with litigation, is that the latter attempted to stuff JPMorgan, as the Lehman triparty clearing house, with about $7 billion in collateral for which Barclays had suddenly gotten buyers remorse and decided it had no desire for, after prices plunged in the days after the Lehman bankruptcy.
Triparty repos are a subset of the broader repo market. As the name implies, a repo is a simple transaction where the holder of a security obtains funds by selling that security to another market participant with the understanding that the security will be repurchased at a fixed price on some future date. Very much like a simple mortgage transaction, the seller is borrowing funds against the security, usually as a means of financing the original purchase of the security. The buyer is traditionally a pension fund, a money market mutual fund, or a bank, which makes what it assumes is a safe collateralized investment (using haircuts, more on that shortly), and in exchange it is paid a spread on the money forwarded. In today's economy most repos occur as triparty contracts, in which the clearing bank assesses the value of the collateral and imposes a haircut, or the difference between the estimated market value and a downside case for how much a lender can borrow. Logically, the size of the haircut reflects the collateral's riskiness. The following table which we presented previously discloses that haircuts determined by JPMorgan in the JPM/Lehman/Fed triparty repo. As one can see, the amount of haircut wiggle room is huge, and even when the taxpayer's money is on the hook for the full repo amount, the haircuts are still relatively tame. Yet if the fair value of the collateral is not properly determined for in a downside case, it pressures accelerated unwinds as banks are fully aware that what they have marked their securities making up their repos for an above FV. What results is a scramble for the exits as everyone attempts to unwind their repos first thereby causing a feedback loop where selling begets more selling, and the entire repo market grinds to a halt.
Why are haircuts an issue?
The repo market is huge. At its peak it was bigger than the Money Market. At the Bear Stearns collapse in March 2008, there was over $4.5 trillion in repos (contrast that to Money Markets which peaked at around $3.8 trillion), of which the bulk is in overnight repos (we will get into the maturity variation on repos in a second). The chart below indicates the phenomenal growth of the repo system, as the banking system glutted itself on free and excessive credit over the past decade. From 1997, through its peak just over ten years later, the amount of outstanding repos at Primary Dealers increased by over 400%!
A critical observation is that beginning in about 2005, the amount of overnight repos quickly overtook the term repo outstandings.
