Can Geithner Save Investors From Shadow Banking?

U.S. Treasury Secretary Timothy Geithner is trying to speed up reforms to a portion of the banking sector that has been largely ignored by regulators, despite its central role in the financial meltdown: the triparty repo market.

An unregulated section of the banking system
The repurchase agreement has become an enormous -- and integral -- part of the global banking system over the past 30 years or so. Just as banks rely on retail deposits to fund mortgages and other loans, the big money that institutions use to finance the everyday business of trading, investing, and other banking activities has come to rely heavily on banking done in the shadows, out of the sight of Main Street and regulators.

Regulators are aware of it, of course, and there's nothing illegal about it. Banks borrow huge sums of money at short-term rates from lenders such as money market mutual funds, which collect vast sums from investors on a regular basis. While waiting to invest these funds, managers take advantage of the repo market to earn some interest on the money. Sometimes these loans are for overnight only; more often, though, they are renewed over and over, or agreed upon by the parties to last several days to several weeks.

Essentially, the parties agree that that the lender will buy bonds from the borrower, such as Treasuries or mortgage-backed securities, with the latter buying these instruments back the next day, with interest. The MMMF makes a little money, and banks such as Morgan Stanley, Goldman Sachs (NYSE: GS  ) and Citigroup (NYSE: C  ) get to use the money to make higher returns on activities like trading or making long-term investments, and everybody's happy. When it works, it works beautifully. But, when it fails -- as it did in 2007-2008, disaster ensues.

Astronomical growth in the repo market
The current repo market is estimated to be approximately $1.8 trillion. Compare this to 1979, when the value of outstanding repos was more like $45 billion, and you can see how the market has exploded over the past 30 years. During the early 2000s, securitization activity rose, and mortgage debt became a more dominant ingredient in the securities used as collateral. These two scenarios helped set the stage for the repo market collapse.

As Fed Chair Ben Bernanke has noted, exotic mortgages and declining home prices in 2006 triggered defaults on MBSes which were scattered around almost every security instrument being created. This meant that no one knew how vulnerable particular securities actually were, which made investors sweat. By 2007, as Gary B. Norton has explained, the margins required by lenders began to increase as they saw risks rising. These haircuts were zero prior to August 2007, but began steadily rising as defaults increased. This made short-term loans more expensive for banks, as they had to put up securities worth increasingly more than the loans they were obtaining.

Eventually, haircuts became unaffordable, or funds were unavailable. As shocked investors saw the writing on the wall, a panic ensued. Loans were not renewed when they were expected to be, or were called in early. Banks dumped assets in an effort to keep up, an impossible goal. Insolvency followed, creating a domino effect throughout the banking system. Bear Stearns fell in early 2008, and a sale to JPMorgan (NYSE: JPM  ) was brokered by the Fed. By September, Fannie Mae and Freddie Mac were also going under. Next came Lehman Brothers, and Merrill Lynch, which was absorbed by Bank of America (NYSE: BAC  ) .

What about money market mutual funds?
The heavy involvement of MMMFs in the shadow banking industry has raised concern that, without some regulations, the whole house of cards could fall again. Although Dodd-Frank did not speak to the repo market in its reform measures, it did provide for a new Financial Stability Oversight Council to be set up to scrutinize financial situations not covered by other agencies. It is through this new council that Geithner seeks to impose rules to protect taxpayers, banks and investors from another run on the repo market. Currently, the Fed, SEC, and the Federal Reserve Bank of New York keep an eye on those entities involved in the repo market.

Regulating MMMFs will not be easy, and the industry has already balked at changes the SEC tried to implement this past August. SEC Chair Mary Shapiro attempted to bring forward rules that would require fund managers to create larger cash reserves, much like banks, or to be more flexible in the guarantees they make to investors. The latter scenario would take the pressure off of having to pay back every dime investors put into the funds. Even though the Fed and Treasury agreed with this plan, it stalled, and the new changes have not been made.

According to Bloomberg, Geithner is also pressuring the Bank of New York Mellon (NYSE: BK  ) and JPMorgan, which process 80% and 20% of all triparty repurchase agreements, to speed up reforms. Both banks are working on computer upgrades that will free them from having to put up money for a period of time until deals clear. Additionally, the Fed would like to see rules in place to protect the banks in case of dealer defaults.

Will these new rules help prevent another crisis?
Certainly, Geithner's reforms will help protect the clearinghouses from defaults. The SEC rules would have protected investors in MMMFs, either by forcing funds to put up reserves to cover losses, or by letting investors know upfront that guarantees on monies invested could ebb and flow according to circumstances, and they might have to wait to get their money back. If the SEC dawdles too long, Geithner may prod the FSOC to promulgate such rules -- and enforce them.

Shadow banking isn't going to go away, nor should it. Some parameters might force it to shrink a bit, however, perhaps making it more manageable. A panic run and too much debt outstanding were the prime ingredients for failure four years ago. The sooner new rules come into play that reduce both those risks, the better.

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Fool contributor Amanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America. Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter services free for 30 days.

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  • Report this Comment On October 01, 2012, at 5:56 PM, neamakri wrote:

    "banks such as Morgan Stanley, Goldman Sachs (NYSE: GS ) and Citigroup (NYSE: C ) get to use the money to make higher returns on activities like trading"

    So: they can borrow money overnight to gamble on the stock market. And how is that good for me? NOT!

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