Learning outcomes: Explain how counterparty risk and liquidity risk can arise through the use of repo transactions. Assess the role of repo transactions in the collapses of Lehman Brothers and Bear Stearns during the 2007-2008 credit crisis. Compare the use of general and special collateral in repo transactions. Describe the characteristics of special spreads and explain the typical behavior of US Treasury special spreads over an auction cycle. Calculate the financing value of a bond trading special when used in a repo transaction.
Questions:
514.1. At the time of the Bear Stern's demise in March 2008, Paul Friedman was a Senior Managing Director at the firm with responsibility for its fixed income repo desk. About the repo market's role in the collapse of Bear Sterns, he said in testimony before the Financial Crisis Inquiry Commission, "During the week of March 10, 2008, Bear Stearns suffered from a run on the bank that resulted, in my view, from an unwarranted loss of confidence in the firm by certain of its customers, lenders, and counterparties. In part, this loss of confidence was prompted by market rumors, which I believe were unsubstantiated and untrue, about Bear Stearns’ liquidity position. Nevertheless, the loss of confidence had three related consequences." Each of the following was one of his cited three consequences EXCEPT which was not?
a. Prime brokerage clients withdrew their cash and unencumbered securities at a rapid and increasing rate
b. Repo market lenders declined to roll over or renew repo loans, even when the loans were supported by high-quality collateral such as agency securities
c. Counterpart to non-simultaneous settlements of foreign exchange trades refused to pay until Bear Stearns paid first
d. Short sellers seized on the panic and drove the stock price down which reduced equity capital available, and equity capital was already the least stable source of funds
514.2. In contrast to general collateral (CG) repo rates, which of the following is TRUE about special repo rates?
a. Special rates are typically less than general collateral rates
b. If the counterparty's primary motivation is to lend cash rather than borrow a security, the special rate applies
c. Special rates are well-suited to repo investors who are looking to obtain the highest rate for the collateral they are willing to accept
d. The most commonly cited special rates are for overnight repos where any U.S. Treasury collateral is acceptable
514.3. In regard to special spreads, each of the following is true EXCEPT which is false?
a. On-the-run (OTR) issues tend to trade more special than off-the-run (OFR; aka, old) issues
b. The special spread equals the general collateral (GC) rate minus the respective bond repo rate
c. On-the-run special spreads peak immediately after an auction, and tend to decrease over the cycle, reaching their lowest level immediately before the next auction
d. Special spreads tend to be volatile on a daily basis (reflecting supply and demand for special collateral) and special spreads can be quite large (e.g., hundreds of basis points)
Answers here:
Questions:
514.1. At the time of the Bear Stern's demise in March 2008, Paul Friedman was a Senior Managing Director at the firm with responsibility for its fixed income repo desk. About the repo market's role in the collapse of Bear Sterns, he said in testimony before the Financial Crisis Inquiry Commission, "During the week of March 10, 2008, Bear Stearns suffered from a run on the bank that resulted, in my view, from an unwarranted loss of confidence in the firm by certain of its customers, lenders, and counterparties. In part, this loss of confidence was prompted by market rumors, which I believe were unsubstantiated and untrue, about Bear Stearns’ liquidity position. Nevertheless, the loss of confidence had three related consequences." Each of the following was one of his cited three consequences EXCEPT which was not?
a. Prime brokerage clients withdrew their cash and unencumbered securities at a rapid and increasing rate
b. Repo market lenders declined to roll over or renew repo loans, even when the loans were supported by high-quality collateral such as agency securities
c. Counterpart to non-simultaneous settlements of foreign exchange trades refused to pay until Bear Stearns paid first
d. Short sellers seized on the panic and drove the stock price down which reduced equity capital available, and equity capital was already the least stable source of funds
514.2. In contrast to general collateral (CG) repo rates, which of the following is TRUE about special repo rates?
a. Special rates are typically less than general collateral rates
b. If the counterparty's primary motivation is to lend cash rather than borrow a security, the special rate applies
c. Special rates are well-suited to repo investors who are looking to obtain the highest rate for the collateral they are willing to accept
d. The most commonly cited special rates are for overnight repos where any U.S. Treasury collateral is acceptable
514.3. In regard to special spreads, each of the following is true EXCEPT which is false?
a. On-the-run (OTR) issues tend to trade more special than off-the-run (OFR; aka, old) issues
b. The special spread equals the general collateral (GC) rate minus the respective bond repo rate
c. On-the-run special spreads peak immediately after an auction, and tend to decrease over the cycle, reaching their lowest level immediately before the next auction
d. Special spreads tend to be volatile on a daily basis (reflecting supply and demand for special collateral) and special spreads can be quite large (e.g., hundreds of basis points)
Answers here:
