If the United States commits hari-kari next week and defaults on its debt, whatever market mayhem ensues will affect the $10 trillion repurchase-loan market.
This is the market in which financial institutions engage in overnight loans among one another, technically selling collateral to lenders with a promise to buy it back the next day. In reality the lender usually agrees for its cash or securities to be rolled over. This liquidity is used to finance everything from prop trading to mortgage lending.
“Repo is the key point of leverage for most other markets,” says one buy-side liquidity expert in the US. It is the blood circulating through the shadow banking system. In 2008, loss of confidence in Bear Stearns and Lehman Brothers was communicated through the repo market, and when their overnight funding dried up, they were immediately made insolvent.
Big fund managers also participate in the repo market. The money-market desks at the likes of BlackRock, Pimco and Western will buy repo loans for their portfolios (see our story yesterday on money-market funds). Hedge funds, mutual funds, pension funds and other buy-side institutions also play in the repo market, to make a spread on providing short-term liquidity to banks.
We’ve seen what happens when repos freeze. But what is the impact on repo markets if the United States defaults on its debt payments? This is not a case where the market loses faith in a particular financial institution (like Bear or Lehman) and stops lending to it, but in which the securities most used as risk-free collateral suddenly become risk assets.
The market could be hit in two ways in the event of a default, or even a downgrade of America’s credit rating: in terms of operations and liquidity.
The Lehman collapse led to haircuts being charged for borrowing everything: Treasuries, inflation-linked bonds, agency MBS. So a shock to the system would no doubt see a repricing in the repo market – which would cascade into a repricing across the board.
As one bond fund manager puts it: “This sounds clumsy, but repo is the mark-to-market market. If US Treasuries are repriced, you’ll see a lot of margin calls.”
Another way to think of it is as a huge deleveraging event, which leads to a liquidity situation. Treasuries currently trade in the repo market with no haircut. They’re the risk-free rate for overnight borrowing.
But if there’s a default, or even just a downgrade, the repo market is where haircuts will begin to be charged on accepting Treasuries as collateral. The risk/reward equation will change – to what degree, no one cares to predict – and everyone in the financial industry will be required to post collateral. That will create a liquidity issue. Potentially a big one, depending on market sentiment.
“It’s hard to discuss,” says a buy-side liquidity manager. “We’ve never faced this before.”
This suggests a problem with the current insouciance in global fixed-income markets. Ten-year Treasuries continue to yield a modest 3%. Many investors are convinced the US will remain a safe haven in a default, because there aren’t better alternatives.
But it’s the repo market repricing that will determine to what extent a credit event would turn into a liquidity event – not what bond-fund managers or Asian central bankers necessarily decide in terms of asset allocation.
In the event of a downgrade, one fund manager says the repo market will remain open, but with a “new risk-appetite profile”. He thinks it will remain open if there’s a default, too, but the repricing could be severe.
However, the repo market does have resiliency. The value of collateral is defined in standard documentation. For money-market funds, for example, acceptable collateral is often defined as securities backed by the government – it doesn’t specify that such collateral must be rated triple-A.
If there’s a default, investors seeking to get out of repo markets would have limited alternatives. Prime money-market funds and certificates of deposit are likely to experience a mass exit. But there could be a rush to buy US Treasuries, as a safer bet.
“There would be demand for more margin, a change in haircuts, especially for longer-dated collateral,” says one buy-side participant. “Who knows how that would affect yields on Treasuries? Would they go up – or would they experience a flight to quality?”
A Morgan Stanley research report released today says: "The market weakness the past few days highlights the growing risk to risky assets, though fears of a big jump in Treasury rates are overstated." It also thinks a downgrade unlikely or, if only made by a single rating agency, less impactful.
Even if the Treasury market isn’t unduly harmed, however, a default or a downgrade by the 'big three' rating agencies would raise significant questions for all investors, especially global sovereigns holding US assets.
“If the US is no longer the risk-free rate, where do you go?” wonders one buy-side executive. A default would spread through financial markets and higher interest rates would probably lead to economic contraction worldwide. That makes spread products such as emerging-market bonds, high yield and mortgages unattractive, but it doesn’t suggest a Lehman-type crisis.
It’s also possible that repo markets would not face a liquidity problem. They might just lead to haircuts on Treasuries rising to, say, 104% or 105%. If the Federal Reserve Bank intervenes in the repo market by pumping in liquidity, then any impact could be moderated. In 2008, such backstops didn’t exist; today the Fed has the authority to provide more liquidity, and it's had time to prepare.
At the end of the day what may matter most is confidence in counterparties, not what the US government does. Documentation has been strengthened following the Lehman shock. This past week or so, fund managers, brokers, banks and custodians have been busy working out lines of communication and defense.
Says one buy-side official: “Repo markets would demand a haircut, but clients will continue to use US securities as collateral. Even if there’s a default, investors would still believe in the full faith in the US. Yes there is a mark-to-market risk, which suggests investors should be in the least-bad place. And that’s still the Treasury market.”