A Proposal for the Resolution of Systemically Important Assets and ...

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On the other hand, the advantage of market discipline through the automatic stay approachisthatittransferstheentireriskoftherepotransactiontotherepofinancier–to someextenttheriskofthecollateralbutalsothatoftheborrower’sabilitytopay.Thisway, other thanthrough expost forbearance, private marketsareallowed to function – bear and pricerisks–andtherebyprovideincentivestotakeaccountofrelevantriskreturntradeoffs. Thereare,however,severalcountervailingissuesthatarise.First,sincetheprimaryissuewith repocontractsistheirsystemicexternality,itisunclearthatprivatemarketoutcomeswouldbe necessarily efficient from a riskreturn standpoint of the economy as a whole. Second, automaticstayintroduces“basisrisk”intherepocontract,sinceitseventualpayoffislinked notjusttotheunderlyingassetbuttothewholepoolofassetsoftheborrowerandtherestof itscapitalstructure.Ingeneral,thismaycreatesufficientexante,aswellasexpost,uncertainty toreducethefinancier’swillingnesstolendagainstcertainassetstoalltypesofborrowers.The result might be a significant reduction in ex ante liquidity in some parts of repofinanced securitizedmarkets.Third,arationaleforthebankruptcyexemptionofthereposhasbeenthat when the borrower defaults, counterparty risk transmission is reduced as far as the repo contractgoesbecauseitisprotectedfromanyspilloveroftheborrower’sremainingrisksand liabilities. Given this relative assessment, our preferred approach is one that facilitates a ready winding down of the repo contracts as far as reasonable liquidity for repo financiers is concerned and at the same time eliminates disorderly fire sales of underlying assets. In particular, the approach consists of setting up a Repo Resolution Authority that meets the criteria1)5)welaidoutintheIntroductionforresolutionofSIALs.Incaseofdefaultofarepo counterparty(theborrower),thereporesolutionauthoritywouldensureorderlyresolutionof itsrepoliabilitiesandalsoanorderlyliquidationoftheunderlyingcollateral;ingoodtimes,the reporesolutionauthoritywouldensurethattheservicesitprovidesattimeofdefaultarenot contributingtoexcessiveriskofdefaultsintherepomarkets. Specifically,institutingthereporesolutionauthorityrequiresthefollowingpieces: 1) Incaseofdefaultofaborrower,itsrepocounterpartiesonTreasuries,andperhaps agencybacked securities (assuming the agencybacked securities are effectively governmentbacked),are“exemptfromstay”andcounterpartiesareallowedtotake theircollateralasunderthecurrentarrangements. 2) However, repo counterparties on risky collateral, such as ABS and MBS, are subjectedtoa“stay”(orasuspensionofconversiontoimmediacy)aswithsecured borrowingofnonfinancialfirms. 3) Immediately upon default, repo financiers of risky collateral are paid by a “repo resolution fund,” a recovery amount that is based on a conservative value assessmentofthecollateral. 28 Suchavalueassessmentcouldbebasedonmarket 28 Thereporesolutionfundcouldbededicatedtothereporesolutionauthority,oritisconceivablethatitcould simplybewithintheFDICortheFederalReserve.Thefundshouldpotentiallybeeligibleforparticipatinginthe 26
intelligence, historical estimates, projected valuations obtained from a poll of dealers, etc. The important issue is that the assessment should be “conservative” andreflectreasonablehaircutsthatanassetliquidatorwouldexpecttoincurwhen faced with asset liquidations. In particular, the conservative value could be dependentonthetotalsizeofrepoliabilitiesofaborrowerand/oronthetotalsize ofliabilitiesagainstagiventypeofcollateral.Theconservativerecoveryamount(or itschedule)should,however,bepredeterminedandknowntomarketparticipants. 4) Incaseofdefaultonrepobackedbyriskycollateral,theunderlyingrepocollateralis takenoverbythereporesolutionauthority(whicheffectivelyhasliquidationrights overthecollateral)andliquidatedinanorderlymanneroveraprespecifiedperiod, say, not more than six months (but with some flexibility to deal with unexpected circumstances). a) Iftheeventualrecoveryonthecollateralisgreaterthantheconservative estimatepaidtotherepofinanciers(seestep3)above),thenthetime valueadjusteddifferenceispaideventuallytotherepofinanciers. b) Conversely, if the eventual recovery is lower than the conservative estimatepaidtotherepofinanciers,thetimevalueadjusteddifferenceis “clawed back” from the repo financiers. The clawback feature would havetobeexplicitlylegislated(aswiththecurrentmechanismusedby FDICtodealwithuninsureddepositorsoffailedFDICregulatedbanks). 5) Ineffect,steps3)and4)resemblealenderoflastresort(LOLR)operation,whereby risky collateral in times of a systemic crisis would be provided liquidity, albeit conservatively at a “haircut” or penalty rate. The operation is of the LOLR flavor sinceitsuspendsimmediateconversiontocurrencyforrepofinanciersintheform ofcollateralliquidationsandreplacesitwithanupfrontbutconservativepayment byreporesolutionfundattimeofdefault,withrightstoliquidationconferredupon thereporesolutionauthorityandnotonrepofinanciers. 6) Incaseofanisolateddefaultintherepomarket,thatis,defaultinatimewhenthe underlying collateral market is reasonably liquid, the collateral liquidation by the reporesolutionauthoritywouldberelativelyswift,atclosetofundamentalorliquid collateral values, and effectively the repo financiers will be repaid conservative amount plus the additional recovery within a few days. That is, in this case, an effectiveautomaticstayonrepocontractswouldbejustacoupleofdays. 7) However,incaseofclustereddefaultsofseveralcounterpartiesintherepomarket, e.g.,becausethereisanaggregateshocksuchasasignificanthousingpricedecline lenderoflastresortfacilitiesofthecentralbank.Ifsuchparticipationisnotclearapriori,uncertaintyconcerningit couldleadtobreakdownofourproposedresolutionplan. 27
Page 1 and 2: AProposalfortheResolutionofSystemic
Page 3 and 4: 2) There needs to be a procedure fo
Page 5 and 6: Furthermore, even the FSB issued ne
Page 7 and 8: feefortheliquidityenhancementprovid
Page 9 and 10: 3) Title II: The prohibition of bai
Page 11 and 12: perceivedinsurancethatcoverstheloss
Page 13 and 14: then it gets treated as being sold
Page 15 and 16: transactions, called term repos, ha
Page 17 and 18: andseveralothersarguedthatthisdecis
Page 19 and 20: III.2RepoMarketandtheCrisisof200709
Page 21 and 22: Consider for instance the “run”
Page 23 and 24: duringthecrisisof20072009.Indeed,in
Page 25: Atoneextreme,some(mostnotably,Gorto
Page 29 and 30: in a)c) above may mitigate credit r
Page 31 and 32: Havinghighlightedthevariousbenefits
Page 33 and 34: Forexample,althoughitdidnotbecomeop
Page 35 and 36: ethesimplestwayofachievinginternati
Page 37 and 38: Acharya,V.V.andM.Richardson(editors
Page 39 and 40: Figure1:MonthlyAveragesofDailyOutst
Page 41 and 42: Trillions of dollars, monthly avera
Page 43 and 44: Source:S SECChairma anChristoph her
Page 45 and 46: Figure7:QuarterlyAveragesofDailyFin
Page 47: Box1:TimeLineofImportantEventsinthe

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