Fails In Treasury Repo Market Caused By Cash Shortages

Bloomberg reports that repo failure remedy drives away bond short-sellers.

(emphasis mine) [my comment]

Repo Failure Remedy Drives Away Bond Short-Sellers
By Liz Capo McCormick
April 30

[This Bloomberg article is so flawed and misleading that I have cut out 90% of text. The only parts I have left are some facts I want to highlight]


...

A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting tomorrow.

...

Interest rates near record lows and surging demand for the safety of Treasuries [and cash shortages] pushed the amount of bad trades to a record $5.3 trillion in the week ended Oct. 22.


Securities as Collateral

The penalty proposed by the TMPG, an industry committee formed by the Fed in 2007, would add an incremental cost of $833.33 dollars per day on a failure of $10 million worth of bonds, according to data compiled by Bloomberg.

In a repurchase agreement, one party provides securities as collateral to another in exchange for cash [This is key. There is no problem in the cash market for treasuries, only the repo market].

...


Trading failures fell to as low as $81.06 billion in the week ended April 8, before rising to $272.4 billion the following week, according to New York Fed data.

...

Penalties for uncompleted trades will begin to accrue May 1. The due date for filing claims for fails to counterparties in trades that occur in May will be June 12, and payment or claim rejections will be due on June 30. In subsequent months the filing date will coincide with the 10th business day and the payment date will be on the last business day of the following month.

Because the penalties will be imposed across the government debt market, unregulated investors such as hedge funds will be held to the same standard as banks and bond dealers. Since it's a recommendation, some dealers are still uncertain which counterparties will need to pay the penalty. [Interesting comment. It suggests that the cash side of treasury repos might be responsible for failed repo, producing confusion about who must pay the penalty.]

Investment News reports about delivery failures plaguing treasury market.

Delivery failures plague Treasury market
Total hit a record $2.29 trillion as of Oct. 1
By Dan Jamieson
October 19, 2008, 6:01 AM EST

The credit crisis is causing a growing number of delivery failures with Treasury securities.

The latest data from the Federal Reserve Bank of New York showed that cumulative failures hit a record $2.29 trillion as of Oct. 1. The federal settlement period is T+1 (trade date plus one day).

The outstanding U.S. public debt is $10.3 trillion.

"Current [fail] levels are at historic levels," said Rob Toomey, managing director of the Securities Industry and Financial Markets Association's funding and government and agency securities divisions. "There's been significant flight to quality" with the market turmoil, he said.

With the strong demand for Treasury securities, "some of the entities that bought Treasuries are not making them available in the [repurchase] market, which is the traditional way to get them," Mr. Toomey said.

Unlike some past bouts with high failure rates that involved particular bond issues, the current high fails involve all types of maturities, he said.

This month, New York- and Washington-based SIFMA came out with a set of best practices to reduce failed deliveries.

This year, the New York Fed revised its own Treasury market trading guidelines. Its guidelines, originally released last year, warned that short-sellers "should make deliveries in good faith."

LACK OF LIQUIDITY

Chronic failures can increase illiquidity problems in the market and expose market participants to losses in the event of counterparty insolvency, according to the New York Fed.

"There is a question about there being some impact on liquidity if [delivery failures] last for a long period," Mr. Toomey said.

Many retail investors also own Treasury securities, either directly or indirectly. The Treasury market is also an important fixed-income benchmark, so any liquidity problems can affect all participants.

In extreme cases, chronic fails could cause participants to limit their trading in secondary markets, the New York Fed said.

"Who wants to buy what they're not going to get?" said Susanne Trimbath, a market researcher with STP Advisory Services LLC of Santa Monica, Calif. In a September research paper, she estimated that based on failure rates in 2007 and 2008, the cost to investors from failed deliveries is about $7 billion annually.

The cost arises because sellers don't have access to their money. In addition, the federal government loses $42 million a year in lost revenue, and the states miss out on an additional $270 million in revenue due to excessive claims of tax-exempt income on state-tax-free Treasury securities, Ms. Trimbath said.

She and researchers at the New York Fed said that
some delivery failures are intentional.

As with naked shorting of stocks, naked shorting of Treasuries "allows you to avoid the borrowing costs," Ms. Trimbath said.

"There can be circumstances in a low-rate environment where it's cheaper to fail" than deliver, Mr. Toomey said. Such an environment also reduces incentives to act as a lender of securities, he said.

A 2005 study by the New York Fed confirmed that episodes of
persistent settlement fails are often related to market participants' lack of incentive to avoid failing.

"We've got to get the [Securities and Exchange Commission], the Fed and SIFMA in there to force" Treasury traders to deliver securities, Ms. Trimbath said.

The Department of the Treasury has a buy-in rule for the cash markets, but the repurchase markets rely on contracts, Mr. Toomey said. Currently there are no penalties for failures, and regulators to date have not required disclosure whether the dealer or the client fails to deliver. [Key point]

By industry convention, fails are generally allowed to roll over until they are eventually closed out [disgusting], Ms. Trimbath said.

My reaction: The US financial system is a mess.

1) Bad trades in treasury repo market reached a record amount of $5.3 trillion in the week ended Oct. 22.

2) In a repurchase (repo) agreement, one party provides securities as collateral to another in exchange for cash

3) The Department of the Treasury has a buy-in rule for the cash markets, the repurchase markets rely on contracts (no buy-in rule).

4) Currently there are no penalties for failures in treasury repo market.

5) By industry convention, fails are generally allowed to roll over until they are eventually closed out.

6) Regulators to date have not required disclosure whether the dealer or the client fails to deliver.

7) A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting May 1.

8) Some dealers are still uncertain which counterparties will need to pay the penalty.

9) These delivery failures in treasury repo market are intentional

10) Chronic failures expose market participants to losses in the event of counterparty insolvency

11) Trading failures in treasury repo market fell to as low as $81.06 billion in the week ended April 8.


Suspicions: I still need to do a lot more research on how exactly the mechanics of securities lending works in the stock and treasury markets before I feel confortable making conclusions about what is going on. That said here are some of my suspicions:

Fails to deliver in treasury repo market were caused by shortages of cash, not treasuries

The peak in the naked short selling of treasuries coincided with huge outflows in all other markets due to hedge fund redemption and investor panic. Now, Remember that *****Wall Street Is Addicted To Selling Non-existent Shares*****.

Wall Street has become very adept at the "clearance" part of the transaction -- that is, the taking of a customer's money for the purchase of securities and the charging of commissions and fees for the purchase of securities. But Wall Street has more and more ignored its fiduciary duty in completing the "settlement" part of the transaction that is, delivering the securities the customer has paid for...even though non-delivery of stock is expressly forbidden by Section 9 of the Securities Exchange Act. More often than not, what is "delivered" is an electronic entry in the customer's account representing an IOU for the security they purchased -- an IOU the customer is completely unaware he holds, and which too often is unsupported by any underlying share certificate.

This delinking of the clearance and settlement of transactions has resulted in
hundreds of millions of undelivered equity securities being outstanding on any given day in the U.S. equities markets. This is blatant and outright fraud -- the taking of money for a product which is never delivered. [Agreed]
...
In 2005, the average diversified stock fund returned 6.7%, the average stock rose just 3%, and the small slice of the country known as Wall Street paid its employees $21.5 BILLION just in BONUSES -- over and above their normal salaries. Bloomberg reports Wall Street's 2006 profits are on track to exceed last year's bonus amounts by at least 15 per cent. As these massive and unconscionab le bonuses reflect, when the 11,000 DTCC participants are able to loan out over and over and over again the same shares, and are able to sell shares which don't exist, much of the time never delivering to buyers the securities they thought they had bought, but instead are allowed to deceitfully mark their customer account statements as if they had delivered the shares ...well, this obviously has been extremely profitable for Wall Street firms...to the clear detriment of investors' retirement and investment accounts. [Agreed]

Here what I suspect happened. Broker/dealers used their clients' brokerage accounts as a cheap source of cash:

1) Stock IOUs were sold to unsuspecting brokerage customers, raising cash.
2) In the accounts of customers who traded using margin, stocks were lent out in exchange for cash.

This cash was then used to buy risky high yielding assets, like subprime CDOs squared, and to pay huge bonuses (based on the profits from those risky investments). Today, those subprime CDOs squared and other risky assets are worthless (and bankers keep their bonuses no matter how bad a job they do) which leaves broker dealers with a problem:

1) Cash needed to repay stock IOUs is gone.
2) Cash needed to reverse stocks loans is gone.

So when huge outflows in the stock markets began due to hedge fund redemption and investor panic, broker dealers were short cash which is why they started naked short selling treasuries.

In simple terms, in order to repay their stock IOUs, broker dealers sold 5 trillion treasury IOUs. Does this sound familiar? Using the cash inflows from new investors to pay out the paper profits of old investors? It is called a ponzi scheme (like Madoff)



Looking at the big picture

Broker/dealers used their ability to sell non-existent stocks, (treasury) bonds, and commodities to build up a massive short position (IOUs in these three markets). While they can shift the location of their short position around (sell treasury IOUs to pay back stock IOUs), these Broker/dealers have no hope of ever eliminating it, as the cash needed has been wasted on toxic assets and bonuses. The reason there is a complete lack of transparency in US financial markets (with a partial exception of treasury market) is to hide this short position.

The decrease in treasury IOUs from $5 trillion in October to $81.06 billion in April was probably financed by cash inflows from commodities and commodity related stocks. The rising gold holdings of GLD and growing open interest on the COMEX are evidence of this process.


More on this as I research securities lending...

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2 Responses to Fails In Treasury Repo Market Caused By Cash Shortages

  1. Anonymous says:

    Allan Meltzer had an OP in New York Times today (5/4/2009), "...no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation."

  2. Pak says:

    Thanks a lot for the insight Eric. Just came across your blog yesterday, and was quite impressed with the analysis.

    All this naked shorting going on leaves me wondering what would happen if the ongoing sucker rally comes to an end, and the investors really start redeeming their money from hedge funds. One has to remember that redemptions stayed remarkably low during the Q4'08 crash, and we just need to see what would happen when investors, who were already beaten heavily during the first leg down, will realize that the recent rally in stocks has been caused by nothing else than US Govt perception management.

    CFO's and executives of financial companies are SELLING into the ongoing rally.

    I personally believe we are YET TO SEE the final leg down in stocks and the destruction of confidence to come with it, then FOLLOWED by one last desperate reflation attempt by the Fed and then.. a classic Austrian School "crack up boom".

    Bernanke is fighting deflation with a clear Friedman/Eggertsson script in mind, but humans (even for the purposes of economics) are not Pavlov's dogs where you push button A and everyone reacts in manner B. Moreover, the US of 2009 is much more like Weimar Germany of 1922 than itself of 1929 or Japan of 1989.

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