Still Talking Collateral And Implying Shortage

Repo fails in the past two weeks (the week of August 17 the most current figures) were both more than $192 billion. Though that level is highly elevated, those were actually the fewest fails since mid-June, and the fewest in consecutive weeks since early May. The 8-week average remains about $245 billion, a noticeable increase from even last year’s “dollar” charm.

At the end of May 2014, the 8-week average of repo fails were just more than $100 billion. Thus, since the start of the “rising dollar” period, repo fails have increased, on average, more than two and a half times, often punctuated, as mid-March, by rather alarming extremes. This is a clear, unambiguous signal of collateral problems; i.e., a shortage. Last week I examined how that could be possible considering that the repo system had been completely purged of subprime “toxic waste” years ago leaving only UST’s and surviving MBS to create a seemingly unassailable foundation.

ABOOK August 2016 LIBOR Repo Fails

The answer is that such markets never stand still, especially when risks are perceived the lowest no matter how artificial that low. Former Fed Governor Jeremy Stein referred to “collateral transformation” in his February 2013 speech, arguing that some serious “reach for yield” behavior in securities lending was taking place at the time. In short, money market participants were transforming through the dubious “magic” of financial laws and operative behavior junk bonds of both US corporates as well as, I believe, EM corporate junk. The result of such transfiguration, as always in these kinds of affairs, was that some as-yet significant but unknown part of the collateral pool was made up of once again collateral of very dubious quality. That Jeremy Stein was raising the issue in February 2013 was potentially indicative of the seriousness of the possible contamination.

From there it is not hard to guess the relationship between the junk-bond sell-off and increasing collateral issues in repo, leaving the repo system by this point in 2016 once more short of collateral on an overall, durable basis (even though the junk-bond selloff has paused and bonds in that space rebounded, it is in all likelihood a permanent reduction in terms of repo as haircuts, like subprime years ago, will never be the same easy terms again going forward).

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