Like The Herald Business Journal on Facebook!
The Herald of Everett, Washington
Heraldnet.com

The top local business stories in your email

Contact Us:

Josh O'Connor
Publisher
Phone: 425-339-3007
joconnor@heraldnet.com

Jody Knoblich
General Sales Manager
Phone: 425-339-3445
Fax: 425-339-3049
jknoblich@heraldnet.com

Jim Davis
Editor
Phone: 425-339-3097
jdavis@heraldnet.com

Site address:
1800 41st Street, S-300,
Everett, WA 98203

Mailing address:
P.O. Box 930
Everett, WA 98206

HBJ RSS feeds

Markets need analysis ahead of regulation

SHARE: facebook Twitter icon Linkedin icon Google+ icon Email icon |  PRINTER-FRIENDLY  |  COMMENTS
By James McCusker
Herald Columnist
Published:
Most things are easier to say than to do. And nowhere is that more true than in monetary policy.
If we need an example, the Federal Reserve’s goals of identifying and reducing systemic risk in our financial markets provides an excellent one. The immediate goal, of course, is preventing a replay of the 2008 financial collapse that most of us are still paying a price for. It isn’t as easy as it sounds.
The repo market provides a very interesting example of how difficult the job can be. It is important part of the system, important enough to be the key to understanding how to keep a financial market hiccup from mushrooming into a full-dress panic. And it is big, so big that we don’t know exactly how big it is. Our banks alone borrow more than $6 trillion in that market.
Sometimes called the third-party repo market, it’s a significant source of liquidity to banks and other financial institutions, the kind of liquidity that is needed to keep the wheels of the markets turning and the commercial transactions of our economy flowing smoothly.
Technically, a third party is not necessary to complete a transaction in the repo market, but it facilitates matters, in much the same way that a bartender can facilitate a bet between customers, by holding the money.
The term “repo” in this market is short for “repurchase agreement,” which itself is short for “sale and repurchase agreement.” One party agrees to sell some securities to another person and purchase them back, at a higher price, at some future date. The securities that are most acceptable, and most liquid, in the market include U.S. Treasury bills, notes and bonds and the mortgage securities guaranteed by Fannie Mae and Freddy Mac. Part of the market, though, is supported by “risk securities,” which are private securities, such as equity stocks and collateralized mortgage obligations (CMOs) that have no federal guarantee.
Repo agreements are priced in terms of a rate of interest, and the securities are most often held by a third-party, often a bank or securities firm that specializes in that kind of safekeeping and transaction recording. From a market standpoint a repo agreement in the end is a sale and repurchases deal that looks like a loan, is priced like a loan, and contains risk like a loan.
The history of the repo market is very relevant from a regulatory standpoint. After being largely dormant for decades, this market began to pick up in the 1950s, when our economy began to expand rapidly and the federal deficit began to take off. It then kicked in the afterburners during the latter part of the 1960s, when the introduction of computerized record-keeping lowered transaction costs just in time to accommodate the expanding deficit.
The federal government, through the Federal Reserve, depends on the repo market to insert its huge debt -- $17.5 trillion, currently – into the market without making waves or absorbing the liquidity needed to keep the economy moving.
From a regulatory standpoint, the recent history of the repo market is even more pointed. That market began to tighten up as doubts about the quality of mortgage-backed bonds began to spread. And when Lehman Brothers, the large financial institution, couldn’t get overnight financing in the repo market it couldn’t meet its obligations and simply failed, touching off the near-collapse of our financial system and the Great Recession that followed.
Because of its proximity to the crash, the repo market was a natural target for Congressional reformers and the heavy hand of Dodd-Frank has had an impact, if not yet a clear effect.
The Federal Reserve is taking a more analytical approach to regulating the repo market. Three analysts at the New York Fed, which is responsible for the market operations of the central bank, have written a very useful report that explores one of the very real risk factors in the repo market: the maturity of the transactions, which range from overnight funds to longer term transactions providing liquidity for weeks and months ahead.
In their recent report, called “What’s Your WAM? Taking Stock of Dealers’ Funding Durability,” authors Adam Copeland, Isaac Davis and Ira Selig investigate the weighted average maturity (WAM) of repo transactions by securities dealers.
The paper focuses on repo transactions that are backed by risk assets, not government-backed securities. It shows an improvement in the maturities away from overnight toward more stable, longer term funding.
It is only a beginning, but there is no doubt that this kind of analysis is on the right track to construct effective, non-toxic regulation. We need the efficiency of the repo market system and certainly don’t want to regulate it out of existence.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.
Story tags » Economy, Business & Finance

MORE HBJ HEADLINES

CALENDAR

Share your comments: Log in using your HeraldNet account or your Facebook, Twitter or Disqus profile. Comments that violate the rules are subject to removal. Please see our terms of use. Please note that you must verify your email address for your comments to appear.

You are logged in using your HeraldNet ID. Click here to update your profile. | Log out.

Our new comment system is not supported in IE 7. Please upgrade your browser here.

comments powered by Disqus

Market roundup