Deleveraging leads repo market into mire

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Activity in the US repurchase market for a variety of fixed income securities is mired in a slump as banks and investors adjust to a new regime of using less leverage to boost returns.

The repurchase market helps finance trading activity in bonds and thus performs a crucial role in the smooth functioning of markets.

In a repurchase, or “repo”, transaction, an investor can borrow cash for a short period from another party, using securities as collateral for the loan. Investors with large portfolios of securities can thus lend these out and earn a return over time. Meanwhile, dealers and short sellers set up hedges or bearish trades, using borrowed securities.

The current lower levels of activity illustrate the extent of deleveraging by investors and the balance sheet constraints being imposed on dealers, which has seen them slash their inventories.

“There is less leverage in the system between banks and their customers,” said George Goncalves, strategist at Morgan Stanley.

Dealers say repo activity is unlikely to return to its peaks, as banks have sharply reduced their leverage – from 30 times to one, down to 10 times.

Moreover, the Federal Reserve and the US Treasury, through their programmes for restoring liquidity in the asset-backed securitised markets and removing impaired assets from banks, are supplying repo-like lending outside the current market.

Based on late-March data from the Federal Reserve, the weekly figure for dealers financing inflows for corporate securities has declined to $88bn, down from a peak of $245bn in July 2007 at the height of the credit bubble.

Last September, corporate repo was running at $180bn; it then plunged in the wake of Lehman Brothers filing for bankruptcy and AIG’s secured lending ­problems.

The decline in repo flows across asset classes has been accompanied by declines in bond trading volumes over the past year, according to data at the New York Federal Reserve.

Even the use of Treasury bonds in repo has fallen sharply, down from a peak of $3,000bn when Bear Stearns failed last March, with current activity around $1,858bn. That is below the average volume of more than $2,200bn seen in 2005 and 2006, but flows have risen since the end of December.

Scott Skyrm, senior vice-president at Newedge, a repo broker dealer, said the repo market was liquid for Treasuries and that demand had been growing once more for agency debt and agency mortgage paper.

Fred Brettschneider, head of global markets for the Americas at Deutsche Bank, said: “Repo is now a functioning market. Some investors may not like the prices, but things are much better than six months ago.”

While liquidity has improved, dealers acknow­ledge that there remains substantially less security lending across asset classes by long-term investors who have substantial portfolios of bonds. Overhanging the repo market is the damage inflicted by AIG, whose securities lending business lost substantial amounts of money for the insurer through the use of repo last year.

In general, securities lending operations at funds, insurers and dealers are quite conservative. The most conservative repo strategy is to lend out Treasuries for cash and reinvest that for other Treasuries and pick up small differences in yield.

Greater risk tolerance involves lending Treasuries and reinvesting the proceeds in agency debt, mortgages or corporate debt. More risk is associated with lending Treasuries on an overnight basis and reinvesting the money in longer-dated certificates of deposit for, say, three months to a year.

Traders say AIG went beyond those parameters, helped partly by the fact it was not lending out securities belonging to clients but those from its internal insurance arms. “That enabled AIG to set its own risk tolerance rules and obviously they were running one of the least conservative of security lending programmes,” said a repo dealer.

In recent congressional testimony, Scott Polakoff, acting director of the Office of Thrift Supervision, said: “While much of AIG’s liquidity problems were the result of the collateral call requirements on the credit default swap trans­actions, the cash requirements of the company’s securities lending programme were also a significant factor.”

In total, AIG’s life assurance companies suffered approximately $21bn in losses related to securities lending in 2008.

More than $17bn in federal assistance has been used to recapitalise the state-regulated insurance companies to ensure that they are able to pay their policyholders’ claims. In addition, the Federal Reserve had to establish a special facility to help unwind AIG’s securities lending programme.

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