Repo 105 and the Next Crisis

Remember Repo 105, which was discussed March 12? The Examiner in the Lehman bankruptcy explained it:

Unlike an ordinary repo transaction, Lehman did not record the borrowing of cash from a Repo 105 transaction even though Lehman was obliged to repay the borrowing. Instead, Lehman established a long inventory derivative asset representing the obligation under a forward contract to repurchase the full amount of securities “sold.”3009 As Lehman’s internal Repo 105 Accounting Policy explained, assuming Lehman borrowed $100 cash in exchange for a pledge of $105 of fixed income collateral, Lehman booked a $5 derivative, which represented Lehman’s obligation to repurchase the securities at the end of the term of the repo transaction. The $5 arose from the fact that when it came time to repurchase the pledged securities, Lehman paid $100 cash for $105 worth of securities. The transaction therefore had a $5 value to Lehman reflecting the market value of the “overcollateralization” amount of the Repo 105 transaction. Because it had a positive fair value of $5, the derivative was recorded as an asset under SFAS 133.

My continued irritation with the Bank of Canada’s Central Clearing cheerleading has led me into another thought … Canadian repos are going to settle with central clearing … derivatives are going to settle with central clearing, as discussed on May 11, tangentially on March 17, by John Hull, December 16 and October 5. Lots before then, of course, but those links carry enough information to make the point.

Anyway, the objective of Central Clearing is to increase the chance that no trades at all wil fail, increase the chance that all trades will fail, increase the potential for contagion in the financial system and increase the number of really good jobs available for ex-regulators. I feel quite certain it will do all of those things.

But … what happens when a firm goes down, or is on the ropes? It is overwhelmingly likely that all of its centrally cleared derivative and repo trades will settle in full. That’s the whole point, right? But what if it goes down? The fact that all of these trades settled in full means there will be less money in the kitty to pay off debt holders and commercial paper holders.

Risks to holders of debt and commercial paper have therefore increased, and there may be other implications as well. Remember Confederation Life? When it went down, all of its profitable FX trades settled tootsy-sweetsy, while all of the unprofitable ones (i.e., about half, given hedging) were delayed while the receiver decided who was going to get paid.

The next crisis will see some very strange games being played. Why would you buy commercial paper from a bank or brokerage, when instead you can pay $99 for the future right to sell them a 1-day T-Bill at $200?

Has there been any discussion or analysis of the reordering of creditor priority inherent in wholesale central clearing? I haven’t seen any, but I’d like to. Here in Canada, of course, it’s impossible even to determine the relative seniority of a BA vs. a BDN!

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