By Patrick Fitzgerald
Of DOW JONES DAILY BANKRUPTCY REVIEW
The new resolution authority created by the Dodd-Frank financial overhaul law is ill-suited to handle a run in the repo market, a new paper says, and a "Repo Resolution Authority" is needed to prevent a repeat of the financial meltdown that followed Lehman Brothers Holdings Inc.'s collapse.
The paper, presented last month at the Federal Reserve Board's conference on central banking and the financial crisis, takes aim at overhauling the tri-party repo, or repurchase, market, one of the pillars of the so-called shadow banking system.
The authors propose a "bottom up" stabilization approach that works at the level of what they call systemically important assets and liabilities rather than at the level of the systemically important financial institution that owns them.
"The advantage of the bottom up approach is that it assigns responsibility and a management of an asset class to a clearing house that over time will develop expertise--not just in bad times on how to resolve them--but in good times over how to manage risk of the assets" like repos and derivatives, Viral V. Acharya, an economics professor at New York University's Stern School of Business, said in an interview Friday.
Acharya, who co-authored the paper with Stern School colleague T. Sabri Oncu, defines systemically important liabilities--including repos and over-the-counter (OTC) derivatives--as those liabilities of highly leveraged financial institutions that are assets of other highly leveraged institutions. Systemically important assets include asset-backed commercial paper and "risky" repo collateral like mortgage-backed securities.
Those assets and liabilities are at the heart of the shadow banking system and are afforded a special exemption under bankruptcy law providing counterparties with a "safe harbor" from the automatic stay, which bars creditors from immediately seizing property for payment of a debt.
Dodd-Frank's Orderly Liquidation Authority created a new insolvency regime designed to address the limitations of bankruptcy law exposed by Lehman Brothers Holdings Inc.'s collapse. The OLA is designed to maintain the systemically important operations of the company in order to prevent the financial contagion from spreading.
"There is a great deal of uncertainty of how this is going to work," said Acharya. "But in some sense, that uncertainty is really what you want to avoid at the time of a systemic crisis."
Acharya and Oncu argue that focusing on resolving--that is, taking over and selling or shutting down--a systemically important institution is the wrong approach. Rather, regulators should focus on overhauling the shadow banking system the institutions rely on.
One of the main planks of the shadow system is the tri-party repo market, which peaked at $2.8 trillion in 2008, the year of Lehman's collapse.
Lehman, like other investment banks, depended on collateral-backed credit lines, known as repurchase agreements, or repos, to fund its business. The bank would sell securities collateral to counterparties while agreeing to repurchase those securities later--often the next morning--for the purchase price plus an agreed-to amount of interest with banks like J.P. Morgan Chase & Co. (JPM) acting as a middleman.
The problem with Lehman's reliance on short?term repos for funding was that the assets on its books were predominantly long term, which couldn't easily be unloaded when the investment bank was starved for cash. When investors such as pension and money-market funds refused to provide funding via the short-term markets, Lehman collapsed, and Bear Stearns, which was bought by J.P. Morgan, nearly did.
In addition, one of the largest money-market funds, the Reserve Primary Fund, was highly exposed to Lehman Brothers' collapsing short-term debt, and when it "broke the buck"--its net asset value falling below par--a run on money-market funds ensued. Only after the government guaranteed money-market funds' deposits did the run come to a halt, notes Acharya.
To stem these "repo runs," a key element in the 2008 crisis according to many experts, the authors propose a Repo Resolution Authority that would function as a kind of clearinghouse for the repo market.
Eligible repo financiers would need to meet prespecified solvency criteria and limit the concentration of certain collateral. In return, the authority takes on the liquidation rights itself but provides liquidity to the market in a crisis.
"The history of what we have seen is very clear," said Acharya. "Clearinghouses deal with failures in a much more organized manner."
He points to the failure of MF Global Holdings Ltd., whose brokerage is being resolved under the authority of the Securities Investment Protection Corp. after securities customers' accounts were transferred to new firms, as an example of how a successful clearinghouse approach could work.
"What happened at MF Global was problematic, but the resolution of MF Global hasn't even been an issue," he said.
The OLA gives the Federal Deposit Insurance Corp. the type of receivership powers for "systemically important financial institutions" it has long exercised to manage failed depository banks.
But Acharya has his doubts that the FDIC has the expertise to resolve a financial institution with significant exposure to the shadow banking system. "At the midnight hour, we call the FDIC, but these institutions are more complex than the FDIC can handle," Acharya said.
A spokesman for the FDIC declined to comment.
The paper, "A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market," was presented last month at the Federal Reserve in Washington. It can be read here: http://www.federalreserve.gov/newsevents/conferences/AcharyaOncu
(Dow Jones Daily Bankruptcy Review covers news about distressed companies and those under bankruptcy protection.)
-By Patrick Fitzgerald, Dow Jones Daily Bankruptcy Review; 202-862-3544; [email protected]