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article appreared in The Edge, Malysia, Sep 12, 2011 Structured Repos: The Emerging Norm
By: Jasvin Josen
Repurchase Agreements, better known as Repos have been around the global market for nearly a century now, as a financing tool. After all the years, it is only natural to find that Repos now exist in many forms and are being structured in many ways. In this article, I will explain some interesting forms of the structured repo and conclude with some additional forms of risks that the market bears with these products. In the most classic form, a repo is essentially a cash loan backed by collateral. The cash borrower becomes the repo seller who sells collateral to the repo buyer and receives cash. At the maturity of the loan (which is traditionally only a few days to a week), the repo seller buys back his securities and returns the cash to the repo buyer. Off course, there will be an interest element which is added on. Since it is backed by high quality collateral, the interest rate is typically lower than other forms of unsecured financing in money markets. Chart 1 illustrates this classic repo. Chart 1 The classic repo

The many variations

Repos are now designed to be flexible and efficient to cater for the investors needs, fitting in nicely as a funding element in structured deals. The following two structures will show how repos are used by investors to hedge (or in reverse, gain access to) interest rate risk and credit risk. The Callable Repo Investors prefer entering into longer term repos (term repos) where they can have the luxury of paying a fixed interest rate instead of renewing short term repos at floating market rates. The cash lender is willing to provide this sort of financing but is concerned about the lost opportunity if the market rates rise. So the cash lender of the term repo negotiates the right to terminate (or call) early, or take back a portion of the cash, in case the market repo rates rise above a pre-set level (say 2%). He then terminates the repo, takes back the cash and reinvests it at the higher rates. In fact, this is a combination of a classic repo (valued like a straight bond) and an interest rate call option with a strike price of 2%. Interest rates movement greatly affects the likelihood of calling the repo. To the cash lender, as interest rate rises, the call option becomes more valuable. As interest rates get more volatile, the call option will increase in value as well. While rising interest rates is a benefit for the repo buyer, it is a disadvantage for the repo seller as he has to go out and source immediate financing at a higher rate, when the repo gets called. This special case of interest rate risk is reflected in the value of the call option. The cash borrower who is short the call option will see the value of his option decreasing as interest rates go up. One potential issue in this structure is liquidity risk. The call option amplifies liquidity risk in times of panic as the cash lender can conveniently exit the repo. In these kind of times, the cash borrower may not be able to find another financing counterparty at a reasonable price. Another concern is whether counterparties actually record and value the call option appropriately in their books. In the above example, if the call option is accounted for, the potential loss for the cash borrower will be quantified immediately. Reversed Repos and Securities Lending The Repo Buyer is said to be entering into a reversed repo transaction. He could be a dealer or investor seeking to borrow specific securities in the market, in a short sale transaction. A popular alternative is the Securities Lending type of repo, where cash does not change hands, only a borrowing fee is charged. This form of repos attracts institutional investors

such as pension funds and insurance companies who want to enhance income from portfolios by lending bonds (or equities) for a fee, rather than through a classic repo. The reversed structured repo An extension of the reversed repo is when the investor buys a risky bond (say single-B) and hedges its credit risk with a better rated counterparty (say AA), all in a reversed repo structure. Please refer to Chart 2. The investor pays cash for the bond at the trade and keeps the bond for say a year. During this period, he earns superior returns in the form of coupons from the B-rated bond. At maturity he resells the bond to the bank at par. In case the bond defaults, the investor still gets back par value from the Repo Seller, as the bond is essentially collateral. The investor has hedged the credit risk of the risky singleB bond with an AA rated counterparty. Off course fees will be charged by the Repo Seller, who is usually the investment bank. The risk of both the B rated bond and the Repo Seller defaulting at the same time is perceived to be remote, provided they are not correlated with each other. Chart 2: The reversed structured repo

Additional forms come with additional risks Repos, whether structured or not, come with many risks. The common one includes risk of the counterparty defaulting. In the former, haircuts are normally imposed by the cash lender. Here, instead of forwarding the full cash amount to the cash borrower, a certain portion (for example 10%) is retained by the cash lender as additional security. As the repo matures, if the collateral value falls further, the cash lender will ask for more cash top-ups, or variation margins. However there are other types of less common risks looming and even growing around structured repos. The first of these risks is the build-up of leverage. Repos are frequently

marketed as an attractive leverage tool by banks. With repos, the cash borrower can afford to build a bigger portfolio and hence make ten times the return. Repos play a major part of allowing hedge funds to get highly geared and make multiple returns. Repos also allow banks to be more and more inter-connected in the financial system, contributing to systematic risk. This has been exposed in the 2008 financial crisis but it seems like the same pattern is slowly emerging in Asia. The second risk is the willingness of the Repo Buyer these days, to accept risky collateral. This injects high issuer (default) risk on top of counterparty risk into the structure. These Yield Enhancement Repos come with low collateral value in return for a higher interest payment to the cash lender. Besides risky bonds in corporations and sovereigns, securities can also include equities (domestic and foreign), exchange traded funds and convertible bonds. Off course one could argue that the margin system would take care of this issue. But I recall lenders that were reluctant to impose haircuts on the borrowers before the 2008 crisis when subprime mortgage-backed securities were being accepted as collateral. The third risk originates from the tenor of repos and structured repos that are getting longer and longer. This changes the whole nature of the repo as well as the relationship with the counterparty. Longer tenors, coupled with lower quality collateral amplify liquidity risk in repo markets when the market turns sour. The current accounting environment requires the securities provided as collateral to remain in the original holders balance sheets. On one hand this rightly looks at substance over form where repos are essentially loans, exposing the true gearing of the counterparty. However this treatment was more relevant back in the days when repos were very short term and collateral was typically high rated. When collateral value is sub-standard and counterparties are stuck in the structure for years, the risk profile changes dramatically. The accounting bodies are having heated discussions with the industry in solving this dilemma. Conclusion It is clear that repos are no more just a boring financing tool. The varied structures are inviting more risks globally. As Asias financial markets achieve prodigious growth rates, we may also be achieving the epicentre of the emerging storm.