Wall Street plumbing in disrepair

Yahoo Finance

Here’s a good rule about plumbing: If you become aware of it, then that means there’s a problem.

So it’s probably not a good thing that the condition and performance of the plumbing of the financial markets has become a big issue on Wall Street.

The Federal Reserve Bank of New York is holding a conference today on challenges facing the repo market – a huge, vital and currently pressured arena where banks and investment funds finance their operations. Repo is slang for “repurchase agreement,” a kind of short-term trade in which cash is exchanged for high-quality collateral such as Treasury bonds. It’s the basic day-to-day mechanism for hedge funds, banks and money market funds to lend and borrow cash used to invest and trade.

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Higher capital requirements on banks imposed after the financial crisis has made it more expensive for them to facilitate repo activity, and they have therefore pulled back. The Wall Street Journal reports that four of the largest banks reduced their repo lending by a total of about $90 billion in the first half of 2014 from a year earlier.

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In some instances, this has created an occasional shortage of collateral in the form of Treasuries, and an increase in failed – or unconsummated – repo trades. The shortage of some series of Treasury bonds has also been attributed to the Federal Reserve’s two-year campaign of quantitative easing, now coming to an end, in which large quantities of government paper was siphoned from the market.

Regulators suggest that the curtailing of repo lending is in part a goal of stiffer capital rules. Banks over-reliance on short-term funding sources like repos left them exposed to liquidity crunches and contributed to the Lehman Brothers death spiral. Banks have been forced to use more long-term debt and other secure financing source.

But there is definitely also the risk of dangerous unintended consequences at work here too. Trading liquidity is less reliable, the multi-year binge on bonds has fattened fixed-income fund balances and raised the need for liquidity just as it’s being drained away.

More than a year ago, I wrote about the rickety plumbing of the corporate-bond market, as Wall Street banks have slashed their inventories of high-grade and junk bonds to record lows, even as the total value bonds in the market has exploded. This isn’t a problem when markets are calm and interest rates low and stable.

But the recent sell-off in junk bonds – blamed on a sentiment shift and bumpy European markets – has drawn notice to the difficulty of getting out of bonds, with particular attention on the huge junk-bond exchange-traded funds that must act in a heavy-handed mechanical way.

Related: Fed will delay raising rates for as long as possible: Ablin

None of this has risen to crisis proportions and there is plenty of high-level attention on the issue. But it adds another level of intricacy to the Fed’s ultimate exit from its highly stimulative easy-money policies. These new, more tightly constrained capital markets have not been tested by a true volatility storm – yet.

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