Why The Broker-Dealer Proposal Is Bad; SEC Should Limit Repo Financing

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Why The Broker-Dealer Proposal Is Bad; SEC Should Limit Repo Financing by David Markel CFA of alephblog.

If you have a moment, read this Bloomberg article.  The brokers are utterly dishonest when they say:

Brokers contend that their borrowing is generally less risky than bank lending. Repo financing, for instance, is backed by collateral that can be readily sold to raise cash in case the other party defaults, said Steven Lofchie, co-chairman of the financial services group at Cadwalader, Wickersham & Taft LLP.

“If you think about a bank that is lending 90 percent against a house, versus a broker-dealer taking in 102 percent against a loan of a security, the broker-dealer’s credit risk is exponentially less,” Lofchie said.

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This is true under ordinary circumstances, but not in a crisis, as we saw in 2008.  Seemingly safe securities were no longer safe, because too many overleveraged parties could not hold their positions when the prices of their seemingly safe securities started to fall.  This led to a panic, because of the structural error of financing long-dated securities with short-dated funding.  In a crisis, that is the fatal flaw of repo financing.

I think the proposals of the SEC are decent, and those that the broker-dealers propose are not.  I would go further and abolish repo markets.  They are crisis-bait.  The asset-liability mismatch invites trouble.

The proposal of the broker-dealers is flawed, because they don’t adopt a model where they match assets and liabilities.  Stable systems match assets and liabilities.  Until they do so, they should not be taken seriously.  The math of risk control wars against them.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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