Liquidity Windfalls: The Consequences Of Repo Rehypothecation

Federal Reserve Board – Division of Monetary Affairs

2015-03-30

FEDS Working Paper No. FEDGFE2015-22

Abstract:

This paper presents a model of repo rehypothecation in which dealers intermediate funds and collateral between cash lenders (e.g., money market funds) and prime brokerage clients (e.g., hedge funds). Dealers take advantage of their position as intermediaries, setting different repo terms with each counterparty. In particular, the difference in haircuts represents a positive cash balance for the dealer that can be an important source of liquidity. The model shows that dealers with higher default risk are more exposed to runs by collateral providers than to runs by cash lenders, who are completely insulated from a dealer’s default. In addition, collateral providers’ repo terms are sensitive to changes in a dealer’s default probability and its correlation with the collateral’s outcome, whereas cash lenders’ repo terms are unaffected by these changes. This paper rationalizes the difference in haircuts observed in bilateral and tri-party repo markets, reconciles the partial evidence of the run on repo during the recent financial crisis, and presents new empirical evidence to support the model’s main prediction on haircut sensitivities.

Liquidity Windfalls: The Consequences Of Repo Rehypothecation – Introduction

The 2007–09 financial crisis raised awareness of the potentially destabilizing effects of financial intermediaries’ reliance on wholesale funding. The increased complexity and interconnectedness of the financial system have changed how intermediaries finance themselves and how their liquidity can come into question. In particular, many financial firms finance their positions through repurchase agreements (repos), which are secured loans backed by financial assets. In the context of repos, destabilizing bank runs can manifest themselves through an increase in haircuts, where the cash borrower receives less money for the same collateral, forcing it to finance its position with internal funds. Alternatively, bank runs can be triggered by a lender’s refusal to roll over the repo altogether, implying an abrupt withdrawal of funding.

Despite the considerable literature that emerged on how repo markets developed during the crisis, the empirical evidence is not conclusive on how bank runs evolved. On the one hand, Gorton and Metrick (2012) show a dramatic increase in haircuts during the crisis, effectively forcing borrowers to use more of their own assets to finance their existing positions or to risk selling off parts of their portfolios at fire sale prices. On the other hand, Krishnamurthy et al. (2014) show only a mild variation in margins. They also document that collateral classes, such as private label Asset-Backed Securities (ABS), which did see a reduction in financing seemed to have lost it precipitously.

This paper reconciles these two empirical facts with a stylized model of repo seen from the perspective of a financial intermediary bringing together initial cash lenders with ultimate cash borrowers. The difference in margins between these repo contracts implies a cash surplus for intermediaries, effectively giving them a liquidity windfall through repo rehypothecation.

More specifically, this paper models dealers as intermediating funds between competitive cash lenders — money market funds (MMF) — and prime brokerage clients — hedge funds (HF) — through repos and reverse repos respectively. Hedge funds use the loan to finance the purchase of the repo’s underlying collateral, and dealers use the same collateral to finance the hedge fund’s repo. The two lending contracts are determined endogenously and their terms of trade depend on a dealer’s need for liquidity and each contracts’ resolution in bankruptcy. In modeling dealers’ liquidity needs I assume they have a preference for cash in the initial leg of the loan. That is, a positive cash inflow is more valuable initially than on the final debt payment. The notion is that an influx of liquidity can allow dealers to finance other activities or give them flexibility to supplant any liquidity shortfalls. When modeling dealers’ default risk, I assume they can default for reasons unrelated to their role as cash intermediaries, which counterparties price accordingly. The resolution of the repo and reverse repo in default plays an important role in deciding the equilibrium terms of trade. Specifically, counterparties’ reduced ability to access unsecured claims on the dealer pins down the interest rate/haircut tradeoff.