by Alasdair Macleod, GoldMoney:

Last week’s failure in the US repo market might have had something to do with Deutsche Bank’s disposal of its prime brokerage to BNP, bringing an unwelcome spotlight to the troubled bank and other foreign banks with prime brokerages in America. There are also worrying similarities between Germany’s Deutsche Bank today and Austria’s Credit-Anstalt in 1931, only the scale is far larger and additionally includes derivatives with a gross value of $50 trillion.

If the repo problem spreads, it could also raise questions over the synthetic ETF industry, whose cash and deposits may face escalating counterparty risks in some of the large banks and their prime brokerages. Managers of synthetic ETFs should be urgently re-evaluating their contractual relationships.

Whoever the repo failure involved, it is likely to prove a watershed moment, causing US bankers to more widely consider their exposure to counterparty risk and risky loans, particularly leveraged loans and their collateralised form in CLOs. The deterioration in global trade prospects, as well as the US economic outlook and the likelihood that reducing dollar interest rates to the zero bound will prove insufficient to reverse a decline, will take on a new relevance to their decisions.

Problems under the surface

Last week, something unusual happened: instead of the more normal reverse repurchase agreements, the Fed escalated its repurchase agreements (repos). For the avoidance of doubt, a reverse repo by the Fed involves the Fed borrowing money from commercial banks, secured by collateral held on its balance sheet, typically US Treasury bills. Reverse repos withdraw liquidity from the banking system. With a repo, the opposite happens: the Fed takes in collateral from the banking system and lends money against the collateral, injecting liquidity into the system. The use of reverse repos can be regarded as the Fed’s principal liquidity management tool when the banks have substantial reserves parked with the Fed, which is the case today.

Having inflated its balance sheet following the Lehman crisis by buying US Treasury bonds thereby increasing bank reserves, from 2011 the Fed started to increase its reverse repo position until 2017. In other words, it was taking liquidity out of the banking system, having previously injected massive amounts of it by means of quantitative easing following the Lehman crisis. From early-2017 to October 2018, outstanding reverse repos then halved, implying liquidity was being added. Since then they have increased by roughly half to $325bn, reducing liquidity.^[i]

What spooked market commentators was the unexpected increase in the repo rate, which on Tuesday 17 September suddenly jumped from the previous Friday’s level of 2.19% to as much as 10%. By escalating its repo position, a targeted liquidity injection from the Fed followed as it struggled to maintain control over the repo rate, taking its outstanding repos from less than $20bn to $53bn. The Fed cut its Fed Funds Rate to a target of 1.75-2.0% the following day.

On Wednesday, 18 September the Fed’s repo position increased again from $53bn to $75 bn. Furthermore, on Thursday and Friday respectively the Fed’s repo position remained elevated, reaching $105bn last Monday. Interestingly, overnight dollar Libor declined slightly, in line with the reduction in the Fed Funds Rate, apparently unaffected by the higher repo rates in the US, confirming it is specifically a US problem involving the large banks.

There have been a number of explanations by expert commentators as to why the repo rate rocketed, none of them satisfactory. It reminds one of Verse 29 of Fitzgerald’s Rubaiyat of Omar Khayyam:

“Myself when young did eagerly frequent

Doctor and Saint, and heard great Argument

About it and about; but evermore

Came out by the same Door as in I went.”

Instead, I have a strong suspicion we are seeing the ghosts of past bank failures, most recently in the UK the sorry tale of Northern Rock which I closely observed. For non-British readers, a short reminder: as a licensed bank, Northern Rock was a mortgage lender which got into difficulties in September 2007, before being nationalised the following February. An old-fashioned run with customers queuing outside its branches seeking to withdraw their deposits had alerted the general public to Northern Rock’s problems. It was unable to tap wholesale money markets, because other banks were unwilling to lend to it on an uncollateralised basis.

The establishment missed the point. As Gillian Tett wrote in the Financial Times at the time, there were increasing concerns over how Libor was operating.^[ii] There was a growing divergence in the rates that different banks were quoting in the various currencies priced in Libor, discriminating against the smaller borrowers (actually, an indication of growing counterparty risk, not a supposed failure of Libor). Furthermore, larger banks were reducing their exposure to Libor by sourcing funds from the treasury operations of large companies and using the developing repo market (which is collateralised, unlike Libor – a further indication of increasing systemic concerns) to maintain their overnight balances instead.

I recall vividly being in RP Martin’s office (then a leading money broker – now part of BGC Partners) in December that year, when all Libor offers mysteriously disappeared, leaving borrowers stranded. Having expected for some time that the credit bubble would come to a head and burst, I took this to be a significant signal of a developing crisis.

The following February, Northern Rock, which had depended on money markets for its financing, collapsed and was nationalised by the government, and the great financial crisis duly followed.

Could the erringly similar repo failure today be the ghost of Northern Rock returning to haunt us in New York? If so, we now have a far larger credit bubble to pop, and the figures in the repo market are in tens of billions, instead of tens of millions. This time it is perhaps less obvious to the general public, because old-fashioned public bank runs are probably a thing of the past.

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