Last updated: October 10, 2013 11:49 pm

Big banks make contingency plans for US default

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Big banks and investors are preparing contingency plans to deal with the potential impact on the $5tn “repo market” of the US government missing a payment on its bonds, even as Republicans propose a six-week reprieve for the debt ceiling limit.

The repo market is a crucial financing area for banks, who post their holdings of Treasury securities as collateral for short-term loans from money market funds, insurers and other investors. With the status of short-term Treasury bills being called into question because of the debt ceiling deadlock in Washington, banks are being forced to rapidly reconsider the Treasury securities they can use as collateral.

One senior banker said that three large repo lenders had asked his company, a big US investment bank, to start thinking about how it would amend the agreements for its repo deals to explicitly exclude shorter-term Treasury securities that are viewed as most vulnerable to the gridlock in Washington.

Investors had initially focused on T-bills due to mature on or after October 17, the day the US Treasury department said it would run out of resources to pay its debt. But on Thursday, with Republican leaders proposing a temporary lift in the debt limit, focus quickly shifted to T-bills due to mature in November and December.

“It’s a recalibration,” the banker said. “We’re definitely seeing some pretty big investors looking to exclude these maturities.”

The yield on one-month Treasury bills maturing at the end of November jumped to 10 basis points, after being a relative oasis of calm at 3 bps as recently as Tuesday.

Yields on December bills are also in the double digits as market participants said that a short-term reprieve for the debt ceiling would do little to alleviate the issue of liquidity risk surrounding the use of T-bills as collateral for repo and derivatives trades.

While many repo investors say the risk of a US default is extremely low, concerns over the debt ceiling are depriving short-dated T-bills of their status as highly liquid and safe assets. Fidelity Investments and JPMorgan Investment Management, two of the biggest managers of ultraconservative money market funds, have said they have sold their holdings of Treasury bills due to mature towards the end of October as a “precautionary measure”.

“Investor nervousness in the front end is largely driven more by fears related to a loss of liquidity than a loss of principal,” said Joseph Abate at Barclays. “And because the sector places extreme importance on maintaining liquidity, investors have a strong incentive to step away from transactions or securities that could, even peripherally, be affected by a delay in increasing the debt ceiling.”

At a banking committee hearing on Thursday, Democratic Senator Sherrod Brown revealed that he sent a letter to JPMorgan Chase and Bank of New York Mellon, the two tri-party repo custodians who help arrange roughly $2tn of repo deals, earlier this week asking what impact a default would have on the repo market.

Paul Schott Stevens, president of the Investment Company Institute, which represents mutual funds, exchange traded funds and others, said Treasury securities have been viewed as a safe asset that was essentially the same as cash.
A default would result in a new risk premium for those securities, which would feed into rates on a wide variety of other assets and lending rates.

“Treasuries set the baseline risk-free rate for global rate markets and command a vital role as collateral,” Deutsche Bank analysts said in a note to clients. “Because of this far-reaching scope, it is extremely difficult to accurately quantify the impact of a Treasury default on markets and the global economy.”

With additional reporting by Eric Platt in New York.

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