Fire Sale!

Monday 04/07/14

     Last week I discussed the divergence between value stocks and growth stocks. That trend continued to accelerate last week as investors fled high growth companies in favor of more stable businesses with strong underlying fundamentals. Stocks opened higher after Friday’s jobs report slightly missed expectations, but once again high growth technology stocks were sold heavily almost immediately after the market opened. This was most evident in the NASDAQ index which has a much heavier weighting in technology and growth stocks. The selling pressure in technology stocks eventually led to a broad based selloff. It is also important to note that many of these stocks have been popular among hedge funds and the selling pressure could be intensified by margin calls. This week I want to look at one of the structural weaknesses in the market that the Fed has struggled to find a solution to.
     The repo market is a key piece of the United States financial system, but doesn’t get much attention unless something is wrong. A Repo (short for “repurchase agreement”) is a contract to sell a security (or more likely a portfolio of securities) and also to buy it back at a later date at a higher price. Repos are essentially short term loans, they provide short-term financing for dealers; they also provide money market mutual funds and others with excess cash to earn some interest.
Most repos occur though a tri-party repo system which involves a third-party clearing bank (JP Morgan and Bank of New York Mellon are the two tri-party agents in the United States). The tri-party agent handles the administrative work of valuing the collateral, settlement, custodial services, and various other risk management procedures. The tri-party system produces some significant risks to the financial system during times of stress, because the tri-party agents also rely on the repo market to finance their own operations.
     In 2008, Lehman Brothers and Bear Stearns both had difficulty accessing the repo market before their collapse. At the peak of the crisis, the Reserve Primary Fund (a money market mutual fund), because of exposure to Lehman “broke the buck”, which is to say that its share price fell below a dollar. Since money market mutual funds were assumed to be nearly risk-free, this sparked a wave of redemptions from money market mutual funds. According to a study by Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin, “Approximately $400 billion was withdrawn from prime money market funds by institutional investors in the span of only two weeks, out of total holdings of about $1.3 trillion.” As cash left the money market funds, that meant that there was less money that could be lent to dealers. This added pressure to strained institutions which also meant that more money was pulled from money markets. This feedback loop did not stop until the Treasury stepped in and guaranteed the performance of money market funds, but it has said that it will not do this in the future (I’m doubtful).
     A quirk in the tri-party system increases the fragility of the system. Every morning, tri-party agents will unwind non-maturing (until recently all repos were unwound regardless of whether they matured) repos which transfers default risk from the money market mutual funds and cash lenders to the tri-party agents. Later in the evening, the tri-party agents will transfer this risk back to the cash lenders. However, imagine that the solvency of a dealer becomes an issue. The tri-party agent could decide not to unwind the repo of the struggling dealer, which would leave the money market on the hook in case of default. To avoid that risk, money markets would be reluctant to lend to dealers with questionable collateral or if they fear that the tri-party agent will decide not to unwind the repo. This dynamic between the tri-party agents creates a self-fulfilling prophecy, because even if one party doesn’t think the dealer is a risk, they may choose not to finance the institution simply because they think the other party might view the dealer as a risk.
     The default of a major dealer can also lead to fire-sale risk. If a major dealer defaults and the tri-party agent is forced to take the collateral from the failed institution, they will be forced to choose between two undesirable options. They can either take possession of the failed dealer’s assets or they can sell them into the market. If a major dealer just failed, then it is almost guaranteed to be a terrible time to sell the failed dealers assets, but because the tri-party agent may not be able to absorb those assets onto its balance sheet, it may be forced into a fire sale. In a fire sale the dealer is selling assets at any price it can get which creates a feedback loop of lower and lower prices.
     In October of last year, Fed president William Dudley remarked that, “Current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales, whether by the dealer itself, or by the dealer’s creditors following a default.” These remarks were intended to start a dialogue between the Fed and those involved in the tri-party repo system. However, according to an update from the Fed in February, ”… the risk of destabilizing fire sales of repo collateral by tri-party repo investors in the event of a default of a large tri-party repo borrower—is not currently being addressed by industry participants.” The Fed understands the importance of solving this problem now, while the market is stable, because it will be nearly impossible if they wait until the next crisis rolls around.
     This issue doesn’t get a lot of attention in the media for two reasons: 1) It isn’t easy to explain in a quick and simple way. 2) The system works perfectly until the market is in a period of stress. However, this is one of the biggest and most challenging issues facing the financial system at the moment.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 186.4 -0.13% -0.19%
IWM (Russell 2000 ETF) 114.49 -0.48% -2.2%
QQQ (Nasdaq 100 ETF) 86.37 -1.55% -2.74%

Tri-Party Repo