Just as in any borrowing/lending agreement, both parties in a repo transaction are exposed to credit risk. This is true even though there may be high-quality collateral underlying the repo transaction. Consider our initial example in Exhibit where the dealer uses U.S. Treasuries as collateral to borrow funds. Let us examine under which circumstances each counter party is exposed to credit risk.
Suppose the dealer (i.e., the borrower) defaults such that the Treasuries are not repurchased on the repurchase date. The investor gains control over the collateral and retains any income owed to the borrower. The riskis that Treasury yields have risen subsequent to the repo transaction such that the market value of collateral is worth less than the unpaid repurchase price. Conversely, suppose the investor (i.e., the lender) defaults such that the investor fails to deliver the Treasuries on the repurchase date. The riskis that Treasury yields have fallen over the agreement’s life such that the dealer now holds an amount of dollars worth less then the market value of collateral. In this instance, the investor is liable for any excess of the price paid by the dealer for replacement securities over the repurchase price.
While both parties are exposed to credit risk in a repo transaction, the lender of funds is usually in the more vulnerable position. Accordingly,the repo is structured to reduce the lender’s credit risk. Specifically, the amount lent should be less than the market value of the security used as collateral, thereby providing the lender some cushion should the collateral’s market value decline. The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin or “haircut.” Repo margins vary from transaction to transaction and are negotiated between the counter parties based on factors such as the following: term of the repo agreement, quality of the collateral, credit worthiness of the counter parties, and the availability of the collateral.Minimum repo margins are set differently across firms and are based on models and/or guidelines created by their credit departments. Repo marginis generally between 1% and 3%. For borrowers of lower credit worthiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more.
At the time of this writing, the Basel Committee on Banking Supervision is proposing standards for repo margins for capital-market driven transactions (i.e., repo/reverse repos, securities borrowing/lending, derivatives transactions, and margin lending). These standards would only apply to banks.
Bloomberg Repo/Reverse Repo Analysis Screen
To illustrate the role of a hair cut in a repurchase agreement, let us once again return to the government securities dealer who purchases a 5% coupon, 10-year Treasury note and needs financing overnight. Recall, the face amount of the position is $1 million and the note’s full price (i.e., flat price plus accrued interest) is $1,044,843.75. As before,we will use Bloomberg’s RRRA screen to illustrate the transaction in Figure above.
When a hair cut is included, the amount the customer is willing to lend is reduced by a given percentage of the security’s market value. In this case, the collateral is 102% of the amount being lent. This percentage appears in the box labeled “COLLATERAL” in the upper right and corner of the screen. Accordingly, to determine the amount being lent, we divide the note’s full price of $1,044,843.75 by 1.02 to obtain $1,024,356.62 which is labeled “SETTLEMENT MONEY” located on the right-hand side of the screen. Suppose the repo rate in this transactionis 1.83%. Then, the dealer would agree to deliver the Treasury notes for $1,024,356.62 and repurchase the same securities for $1,024,408.69 the next day. The $52.07 difference between the “sale”price of $1,024,356.62 and the repurchase price of $1,024,408.69 is the dollar interest on the financing. Using a repo rate of 1.83% and a repoterm of 1 day, the dollar interest is calculated as shown below:
$1,024,356.62 × 0.0183 × (1/360) = $52.07
This calculation agrees with repo interest as calculated in the lower right-hand corner of Figure above.
Marking the Collateral to Market
Another practice to limit credit risk is to mark the collateral to market on a regular basis. Marking a position to market means simply recording the position’s value at its market value. When the market value changes by a certain percentage, the repo position is adjusted accordingly. The decline in market value below a specified amount will result in a margin deficit.[Paragraph of the Master Repurchase Agreement (reproduced in the appendix) gives the “Seller” (the dealer/borrower in our example) the option to remedy the margin deficit by either providing additional cashor by transferring “additional Securities reasonably acceptable to Buyer.”The Buyer in our example is the investor/lender.] Conversely, suppose instead that the market value rises above the amount required by margin.This circumstance results in a margin excess. If this occurs, Paragraph states the “Buyer” will remedy the excess by either transferring cashequal to the amount of the excess or returning a portion of the collateral(“purchased securities”) to the “Seller.”
Since the Master Repurchase Agreement covers all transactions where a party is on one side of the transaction, the discussion of margin maintenance in Paragraph is couched in terms of “the aggregate Market Value of all Purchased Securities in which a particular party here to is acting as Buyer” and “the aggregate Buyer’s Margin Account for all such Transactions.”Thus, maintenance margin is not viewed from an individual transaction or security perspective. However, Paragraph permits the“Buyer” and “Seller” to agree to override this provision so as to apply the margin maintenance requirement to a single transaction.
The price used to mark positions to market is defined in Paragraph—the definition of “Market Value.” The price is one “obtained from a generally recognized source agreed to by the parties or the most recent closing bid quotation from such a source.” For complex securities that donot trade frequently, there is considerable difficulty in obtaining a price at which to mark a position to market.
Delivery of the Collateral
One concern in structuring a repurchase agreement is delivery of the collateral to the lender. The most obvious procedure is for the borrower to actually deliver the collateral to the lender or to the cash lender’s clearing agent. If this procedure is followed, the collateral is said to be “delivered out.” At the end of the repo term, the lender returns collateral to the borrower in exchange for the repurchase price (i.e., the amount borrowed plus interest).
The drawback of this procedure is that it may be too expensive, particularly for short-term repos (e.g., overnight) owing to the costs associated with delivering the collateral. Indeed, the cost of delivery is factored into the repo rate of the transaction in that if delivery is required this translates into a lower repo rate paid by the borrower. If delivery of collateralis not required, an otherwise higher repo rate is paid. The risk to the lender of not taking actual possession of the collateral is that the borrower may sell the security or use the same security as collateral for a repo with another counterparty.
As an alternative to delivering out the collateral, the lender may agree to allow the borrower to hold the security in a segregated customer account. The lender still must bear the risk that the borrower may use the collateral fraudulently by offering it as collateral for another repo transaction.If the borrower of the cash does not deliver out the collateral, but instead holds it, then the transaction is called a hold-in-custody repo(HIC repo). Despite the credit risk associated with a HIC repo, it is used in some transactions when the collateral is difficult to deliver (e.g., whole loans) or the transaction amount is relatively small and the lender of funds is comfortable with the borrower’s reputation.
Investors participating in a HIC repo must ensure: (1) they transact only with dealers of good credit quality since an HIC repo may be perceived as an unsecured transaction and (2) the investor (i.e., the lender of cash) receives a higher rate in order to compensate them for the higher credit risk involved. In the U.S. market, there have been cases where dealer firms that went into bankruptcy and defaulted on loans were found to have pledged the same collateral for multiple HIC transactions.
Another method for handling the collateral is for the borrower to deliver the collateral to the lender’s custodial account at the borrower’sclearing bank. The custodian then has possession of the collateral that it holds on the lender’s behalf. This method reduces the cost of delivery because it is merely a transfer within the borrower’s clearing bank. If, forexample, a dealer enters into an overnight repo with Customer A, the next day the collateral is transferred back to the dealer. The dealer can then enter into a repo with Customer B for, say, five days without having to redeliver the collateral. The clearing bank simply establishes a custodian account for Customer B and holds the collateral in that account. In this type of repo transaction, the clearing bank is an agent to both parties.This specialized type of repo arrangement is called a tri-party repo. For some regulated financial institutions (e.g., federally chartered creditunions), this is the only type of repo arrangement permitted.
Paragraph (“Segregation of Purchased Securities”) of the Master Repurchase Agreement contains the language pertaining to the possession of collateral. This paragraph also contains special disclosure provisions when the “Seller” retains custody of the collateral.
Paragraph (“Events of Default”) details the events that will trigger a default of one of the counterparties and the options available to the non-defaulting party. If the borrower files for bankruptcy, the U.S.bankruptcy code affords the lender of funds in a qualified repo transaction a special status. It does so by exempting certain types of repos from the stay provisions of the bankruptcy law. This means that the lender of funds can immediately liquidate the collateral to obtain cash. Paragraph(“Intent”) of the Master Repurchase Agreement is included for this purpose.
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