Tuesday, 14 October, 2008
One of the biggest casualties of the breakdown in trust between financial institutions has been the US government repurchase or repo market, where Treasury debt is borrowed in exchange for cash loans.
After weeks of turmoil since the bankruptcy of Lehman Brothers, there is hope that last week’s sale of $40bn in additional Treasury debt will start unblocking this market which underpins the $4,800bn government bond market.
Those debt sales start settling on Wednesday and should relieve some of the extreme stress in repo, where borrowed securities have not been returned on time in record amounts.
These so called repo ‘fails’ have risen sharply since mid-September and have sparked a record breakdown in the very long chain of lending and borrowing that characterizes the trading of Treasuries between investors.
“The fail situation did not improve the past few days, but there was no reason it would,” said Scott Skyrm, senior vice-president at Newedge, a repo broker-dealer. “The reopening settles on Wednesday, and while I expect to see some light, the door will not completely open.”
Fails to deliver reached $2,290bn while fails to receive totaled $2,500bn according to the latest weekly Federal Reserve data. These greatly exceed previous bouts of repo stress seen i 2001 and 2003.
George Goncalves, strategist at Morgan Stanley said: “Cascading fails result when a seller is unable to deliver securities because of a failure to receive the same securities in settlement in another unrelated transaction.”
A repo transaction helps institutions raise short-term cash when they temporary lend Treasuries they own. Repo also helps investors bet on higher bond yields, by shorting or selling the market, as they can borrow a Treasury. A smooth functioning Treasury market relies on traders and investors hedging interest rate risk being able to both buy and sell yields.
On Tuesday, as has been the case in recent weeks, many current and older Treasury notes and bonds were trading at or near zero per cent. That indicates that a security is failing. At zero per cent, lenders of a note in repo receive an interest free loan on the short-term cash they raise via their Treasury collateral. By remaining at zero for an extended period, the allure of a cheap cash loan has failed to entice holders of Treasuries to lend them out.
This shows just how pronounced fears of the credit risk between banks and institutions have become since Lehman collapsed. Repo traders expect more debt sales from the Treasury as repo fails are very pronounced in the 2013 and 2014 sectors.
More supply should also help normalize general collateral (GC), the rate at which Treasuries in repo are financed. On Tuesday GC averaged 0.15 percentage points and should normally trade near the Fed’s target rate, which is currently 1.5 per cent.
Strong demand for owning Treasuries has kept GC near zero per cent and that has impeded repo transactions as the penalty rate for a repo fail has been low.
Source: http://www.ft.com
