By Karen Brettell and Richard Leong
NEW YORK, Oct 9 (Reuters) - Banks and money market funds arebeginning to shun some Treasuries normally used as collateral inthe $5 trillion repurchase agreement market, a sign that thedeadlock over raising the U.S. debt ceiling could disrupt a keysource of day-to-day funding for the financial system.
Treasuries are often pledged against short-term loans inrepo, funds used broadly across the financial system to pay forinvestment, trading and other operations vital to the day-to-dayactivities of many companies.
On the ninth day of partial government shutdown, investorsare getting more nervous that Congress may fail to raise thedebt ceiling, leaving the United States at risk of defaulting ondebt that comes due or has coupon payments in late October andearly November.
Many financial businesses depend on repo funding, and anydisruption could spread to other markets. So far, liquidityissues appear contained. But even a brief default could causelarge disruptions to payments, settlement and transfers ofaffected Treasuries.
To prepare for that possibility, which is still small, banksand money funds have begun taking steps to avoid any exposure toTreasuries they see at risk of delayed payments. Interest rateson bills maturing at the end of October have risen sharply inthe last week.
"Investors are worried about holding Treasury bills andcoupon securities in late October through the middle ofNovember, which may face delayed payments. Those fears areoverblown, but clearly some people are concerned," said BorisRjavinski, rates and rate derivatives strategist at UBS inStamford, Connecticut.
The overnight rate to obtain cash in repo was last quoted at0.14 percent after rising as high as 0.17 percent, a level notseen since early May and sharply higher than the rate of 0.09percent on Tuesday and 0.07 percent a week earlier.
Some banks have begun to stipulate that they will not acceptcertain Treasuries to back trades. This includes trades theymake with clients and in the interdealer market, where tradesare routed through a central counterparty, the Fixed IncomeClearing Corp (FICC), said traders.
"In the interdealer market, cleared, term-repo trades arestarting to have stipulations that there are no interveningcoupons, which means that some dealers do not want to acceptcollateralized loans that would potentially be affected by amissed coupon payment," said Kenneth Silliman, head ofshort-term rates trading at TD Securities in New York.
At the same time money market funds are shifting theiractivity away from the tri-party repo market, and instead arelending directly to banks, where they can more easily specifycollateral that they don't want to accept for loans.
"There are several money funds that have resorted tobilateral transactions rather than tri-party in order to ensurethey get the collateral they want. Altering agreements at thetri-party is a lot more challenging," said Guy LeBas, chieffixed income strategist at Janney Capital Markets inPhiladelphia, Pennsylvania.
In tri-party trades, JPMorgan Chase & Co or Bank ofNew York Mellon Corp act as intermediaries for lendersand borrowers and arrange for the settlement of the loans andthe collateral behind them.
Traders also said money funds are avoiding buying theaffected Treasuries as part of their regular Treasuriespurchases, while selling of the bills has accelerated this week.
Fidelity Investments and PIMCO have both said that they areavoiding Treasuries bills that mature in the danger zone.
Treasury bill rates continued their dramatic increase onWednesday. The interest rate on the T-bill issue due Oct 17 rose 17.5 basis points to near 0.46 percent, whichwas a level not seen since the height of 2008 global financialcrisis. Several other maturities were also trading at elevatedyields.
U.S. Treasury Secretary Jack Lew has warned Congress theUnited States would exhaust its borrowing capacity no later thanOct. 17, at which point it would have only about $30 billion incash on hand.
Banks have been increasing their borrowing from the FederalHome Loan Banks (FHLB) in recent days, a sign that they arealready aiming to shore up liquidity to offset any disruptionsin the repo market as money funds are increasingly reticent tolend through the tri-party system.
"It appears that the FHLB is lending to financialinstitutions has been implicitly funding some of the pullback inthe triparty repo system," LeBas said.
The ultimate liquidity backstop, were it needed, wouldlikely be the Federal Reserve.
"The Fed has not pulled out its bazooka yet, that would besome form of lending from the discount window or a directlending program that would take all sorts of collateral. Theycan stop liquidity (problems) from spiraling out of control, Idon't think they are near to using it," LeBas said.
- money market funds