Liquidity concerns/dealer banks/ Duffie

[Hend Abuenein]

Hi David,
I hope you're feeling good today.

According to Duffie, if a dealer bank is in a repo agreement, and is denied renewal, then counterparty may sell the colateralized securities. If the sale does not cover the position then the dealer counterparty may face litigation for improper disposal of assets. And if no government party steps in as a lender of last resort, then they would have no where to turn to. "They could reinvest their cash in new repo, but other counterparties are unlikely to take these positions if dealer's solvency is questioned"

This is from Schweser's notes on Duffie, emphasis mine. I'm sorry I have no means of referring to the original reading, but I assume structure of concepts in it is deliberate and conforming.


1- In the emboldened sentence, would you please explain, what improper disposal of assets did the dealer commit?


2- In red, if the dealer bank is the party indebted in the repo agreement, and agreement ends without renewal and in the manner explained, then reinvestment opportunities for their cash would be the last they'd worry about. So how does this relate to the case?


3- Even in the case of a dealer with questionable solvency, if they wanted to invest cash in repos, then why wouldn't counterparties take the position (as said in red)? If a netting clause is embedded in the agreement, there could be chance for these counterparties to gain from the dealer's weakness (adverse selection?)

Thanks

 

[David Harper CFA FRM]

Hi Hend,

Thanks, I hope you are doing well! The source Duffie is free at http://www.garpdigitallibrary.org/display/frm_course_pack.asp
Here is Duffie's paper http://db.tt/MMQW9CeF
I copied the relevant section below, from his paper (similar, not exactly the same).

1. I'm not sure exactly to what Duffie refers, he doesn't exactly say. My guess is that he refers to the liability of the money market fund (the lender who is reverse repo) under Rule 2a-7 (see http://taft.law.uc.edu/CCL/InvCoRls/rule2a-7.html; or more plainly http://www.investopedia.com/articles/mutualfund/10/a-safer-money-market-2a7.asp#axzz1pQRDgIRf ). Money market funds must meet rigid, it appears to me at first glance, collateral requirements (http://taft.law.uc.edu/CCL/InvCoRls/rule5b-3.html#c.1 ) ... so, I'd imagine he's saying, if they lose a lot on their sold collateral, by definition, they've revealed the collateral value wasn't very safe and may face liability. Don't quote me, this is just my quick interpretation.

2. I agree with your red: as i read both the assigned Duffie and his longer paper, I see no such statement in the source. My GUESS is that's a loss in translation. I THINK they mean, and let's just refer to either the "dealer" (who is borrowing cash overnight) or the "creditor" (who lends cash and temporarily holds collateral): the creditors decide it's too risky to re-lend the cash to the potentially insolvent dealer, so rather than rollover, they engage in new reverse repos with OTHER dealers who are highly solvent. And the DEALER is facing a run, and the DEALER can't find new creditors to borrow from. Source: "the repo creditors can avoid these risks and other unforeseen of the collateral. The repo creditors can avoid these risks and other unforeseen difficulties simply by reinvesting their cash in new repos with other dealers."

3. You could be right, but apologies, I am not sure exactly what you mean? Duffie seems to be illustrating the downward spiral in the shadow run: the dealer has used repo to borrow short-term cash from creditors; who then "en masse" decide the haircuts are insufficient, and decide they have better places to lend overnight. I agree with you that it may be an opportunity for money market funds/etc (the creditors) to raise their overnight rate and make a higher overnight return, in exchange for risk, but I think Duffie's underlying narrative is that: the dealer (who relies on borrowing the cash, the dealer's liabilities to fund its own assets) suddenly cannot find counterparties who will lend cash (in exchange for holding securities as collateral). The creditors (e.g., money market funds) in this narrative, they are okay, they just lend to somebody else.

From Duffie's Paper (not the assigment, similar but i think a bit more detail is given): "Although the repo creditors providing cash to a dealer bank have recourse to the collateralizing assets, often with a haircut that protects them to some degree from fluctuations in the market value of the collateral, they may have little or no incentive to renew repos in the face of concerns over the dealer bank's solvency. In the event that the dealer counterparty fails to return their cash, the repo creditors would have an incentive, or could be legally required, to sell the collateral immediately, could discover a shortfall in the cash proceeds of the collateral sale, and could potentially face litigation over allegations of improper disposal of the assets.

The repo creditors can avoid these threats, and other unforseen difficulties, simply by re-investing their cash in new repos with other counterparties. If a dealer bank's repo creditors fail to renew their positions en masse, the ability of the dealer to raise sufficient cash by other means on such short notice is doubtful, absent emergency too-big-to-fail support from a government or central bank. Tucker (2009) has emphasized the importance of broad and flexible lender-of-last-resort financing. Asset resales may result, with potentially destructive impacts on other market participants through adverse marks to market on their own repo collateral. The proceeds of an asset resale might be insufficient to meet cash demands, especially if the solvency concerns were prompted by declines in the market values of the collateral assets themselves. Even if the dealer bank could sell enough assets quickly to meet its immediate cash needs, the firesale could lead to fatal inferences by other market participants of the weakened condition of the dealer."

 

[Hend Abuenein]

Thank you David,

1- I read the link and it clarifies the rule.

2- I think note writers made a mistake here and jumped from paragraph to another confusing sides of repo. I'm going to report it to errata.

3- From the Duffie text you quoted :

...the ability of the dealer to raise sufficient cash by other means on such short notice is doubtful, absent emergency too-big-to-fail support from a government or central bank.

Contradicts your explanation :

...Duffie's underlying narrative is that: the dealer (who relies on borrowing the cash, the dealer's liabilities to fund its own assets) suddenly can find counterparties who will lend cash

I think you only mis-wrote that, since we agree on the concepts .

I believe Duffie emphasizes the dramatic spiral fall caused mainly by the time effect

...he ability of the dealer to raise sufficient cash by other means on such short notice is doubtful

All that is being considered in the run effect on dealer banks are cases of overnight funding which I think are the fastest respondents to any questioning of the dealer's/borrower's solvency, and the repercussions thereafter are what cause the bank's fall.

Thanks

 

[David Harper CFA FRM]

Hi Hend,

2. With a fresh look, I still agree your red sentence is an error; it mistakenly confuses the creditors (who have the cash to reinvest) and the dealer (who need to borrow overnight funds).
3. Yes, agreed, my typo, corrected above. I meant "cannot find counterparties."

Thank you for some thoughtful ideas, I improved my own interpretation of the text!