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Hi Red - have returned from my trip. Have tried to answer your questions below. Feel free to hit me up with any others:
I'd like to ask a couple of questions related to rehypothecation:
1. Is it still permitted in London but not New York?
Red as far as I am aware rehypothecation is still practiced in the US. I’d argue it would be very difficult to run a repo operation without the ability to raise collateral from one party and not lend it to another. The fellow who had to manage repo 105 at Lehman is a friend of mine; hed never talk about it. That particular setup was a last act of desperation: Lehman lent collateral to it’s own SPVs, and the agreements with those SPVs were such that the haircut was always at 5% (105), when the likelihood is that it would have been Lehamn that would have had to take the haircut to lend the paper they had as inventory. The 5% extra cash made it appear every month as though Lehman were okay with their cash balances and not at risk.
2. Is there any place with data on rehypothecation and the number of hair cuts that have taken place? as this to my mind speaks to the contagion risk in the system.
This wouldn’t be publicly available data. Typically at a bank, the rehypo is dressed up as a trading strategy. So for example lets say you (lets call you Nomura) borrow treasuries from JPM, lend them cash, and then lend these treasuries to Deutsche at a favourable haircut. The trading desk at Nomura will link all the related trade tickets together with a strategy, say ‘JPM US Ts on-lend.’ The Deutsche tickets will have this reference and the JPM tickets. Typically it will be the repo sales desk that monitor this, monitor the cash levels etc, recommend close outs to the traders who decline/approve, re-rate, rollover certain of the tickets, or wind the strategy up or down.
//cont//
some more questions if I may:
1. Does to scale of what is required surprise you?
When I first started learning about repo I thought no…this cant be the case. The entire banking system is a daisy-chain? But it most certainly is. The way it is carefully managed by skilful risk mangers/traders limits the exposure to blowing up. The operations for a repo desk are huge. You may have say ten traders, then youll have 6 or 7 sales, a middle office, a back office, a risk team, a collateral management team. For a bank it’s probably the most operationally intense part of the trading floor. Without a repo desk however, most of these banks would have to fold. Imagine when a bank is created, and the treasury is created and it’s capitalised with say $100m. The bank lends that cash out to it’s own traders internally (they pay a funding rate to treasury): the traders take positions; they trade cash for bonds, or swaps etc…either way you have these bonds sitting on the balance sheet doing nothing. Now, the treasury could raise cash via issuing bills or notes, but the rate on those will be related to their credit rating: so for example Bank issues 2 year notes with a coupon (rate) of 8%, to raise say $20m. Instead of doing that, they can get their repo desk to take the bonds on it’s balance sheet, lend them out overnight at say a blended rate of .20%, and raise ~%100m of cash – its better to raise cash via repo than an issuance – that’s one of the most basic motivations.
2. If it does surprise you what are the implications?
Badly managed, the repo desk can blow up the bank. Lets imagine a terrible strategy: your repo desk lending cash at high rates and taking EM collateral in order to boost their profits. Now lets imagine a rush to turn risk down, and the market value of that collateral drops overnight. You as the bank are holding it to maturity, but you are exposed as a bank to the EM collateral. Yes, you are collateralised as your cash is lent, but that’s the issue with repo: Lehman blew up for many reasons, but one of them was that they were exposed to too much MBS/CDS wrapped-up property collateral that they had lent out happily, and didn’t have enough solid government collateral to buffer against a credit event.
What are your thoughts on the idea that JPM or Deutsche could be in trouble, could they be in trouble or are you sticking with your thoughts in your previous note?
JPM isn’t in trouble: it seems to me that they have grown so large that they effectively hold a large amount of available US treasuries. It’s the counterparties that need to borrow from them that can be dictated to more than what an efficient market should allow. I’ve always been of the opinion that Deutsche is going to have to pay via bankruptcy/state rescue for the size of it’s derivative liabilities – but that can keeps getting kicked down the road.
Always happy to help Red. It's a big topic - very closely related to repo are the margining rules that clearing houses require. Perhaps getting off topic here but...
Netting Rules
CCPs like LCH employ netting rules. Imagine if you are a bank and your repo desk concentrates all their collateral in the long end of the maturity curve in germany, the desk being long the bonds (reverse repo). LCH will require large amounts of margin for that in order to cover their own risk and your counterparties risk at the CCP. As a result there are various netting arrangements, i.e. a repo on a 10 year dutch bond can be offset with a reverse on say a 10 year german bond. This nets down the liability, which means less margin needs to be paid over. Given the thin margins in fixed income the last few years, a lot of attention has been placed on getting the margining right.