Digging In to Tri-Party Repos

 | Jan 22, 2013 | 1:00 PM EST  | Comments
  • Comment
  • Print Print
  • Print
Stock quotes in this article:

jpm

,

bk

Last week I wrote about how banks interact with the Federal Reserve, and that elicited some queries about tri-party repurchase agreements. It's a worthy subject, so I'll address it briefly here.

The relationships I discussed pertain to basic two-party repurchase agreements. In these, a bank will either lend to or borrow reserves from the Federal Reserve, with existing high-quality debt assets as collateral, and receive or pay interest during the holding period. These are very paperwork-intensive transactions, because they require actual ownership transfers of the underlying collateral.

In a way, this is similar to owning a beach house that you want to rent out during the summer months. But, rather than it being a simple rental agreement, in this case the law requires the banks to "sell" the property to the "renter" and then "buy" it back at the end of the term (and vice versa).

As a result of this, the concept of tri-party repos was developed. In such a contract, an "agent" will step in between the lessor and lessee, guarantee the transaction and handle all accounting. This reduces the paperwork for both parties.

In the U.S., two banks -- JPMorgan Chase (JPM) and Bank of New York Mellon (BK) -- are charged with acting as Tri-Party agents. In other words, they facilitate transactions in which other banks borrow from and lend to the Fed. When another bank enters a repurchase agreement using JPMorgan or Bank of New York as an agent, they have entered into a tri-party arrangement and carry the collateral for such as "pledged securities." This means they have pledged securities to JPMorgan or Bank of New York Mellon, which in turn pledge securities to the Fed on those banks' behalf.

It's very similar to the way international letters of credit operate. For instance, a Brazilian buyer of U.S. goods will get a letter of credit from their local bank. That bank will, in turn, "guarantee" the payment to the corresponding bank of the U.S. exporter, which allows the exporter to deliver the goods with assurance that they will be paid.

However, potential problems arise if either of the two principal parties default -- or, more important to this discussion, if the guaranteeing bank cannot deliver in the event of such a default. So, for U.S. tri-party repos, the principal concern is whether JPMorgan and Bank of New York can really absorb such risk. Also at issue is whether the banks are managing their risk to allow for crisis events in which several principals may not be able to deliver.

The Federal Reserve and regulators are well aware of this issue. In the event of a crisis in collateral valuations, though, the principal risk is concentrated in JPMorgan and Bank of New York. So, if either cannot deliver, the Fed and the U.S. Treasury would have to focus liquidity injections in them first.

In the past three years, as the Fed has lowered the cost of capital to banks, we haven't seen a substantial net rise in the use of tri-party repos. At Bank of New York Mellon, the percentage of securities pledged to secure repurchase agreements has been maintained in the 80% range. JPMorgan's ratio has also been stable, in the 40% range.

In comparison, the pledged securities at Bank of America (BAC) have declined from 30% to 20%; at Wells Fargo (WFC), the percentage has slid from 60% to 30%. At Citibank (C), the pledged securities have increased from about 50% to about 65% -- though this a logical result of the bank's increased holdings of Treasuries, which it can use to support other banks.

All told, the tri-party risk issue appears right now to be both concentrated and stabilizing. I'll review this issue again within the next few months as I have a chance to review the bank call reports for the fourth quarter of last year.

Columnist Conversations

Market is slightly down at midday. NASDAQ and Russell 2000 outperforming S&P 500 and DJIA, the opposite s...
With the RUT now up on the day, I think the market has hit a near-term bottom and is likely to meander back to...
VIPS pulled backed nicely from the resistance discussed in the last article and has triggered again on the buy...
The 50 day moving average got some attention yesterday when it crossed below the 200 day average on the Russel...

BEST IDEAS

REAL MONEY'S BEST IDEAS

Columnist Tweets

BROKERAGE PARTNERS

Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data provided by Interactive Data. Company fundamental data provided by Morningstar. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by Interactive Data Managed Solutions.


TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

IDC calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.