The risk, less haircut, boomerangs back to the banks. International Management Associates LLC [2006-02] 4. The weaknesses of this approach will sound familiar: moral hazard and difficulty in getting a facility set up quickly enough. With all the stuff we have heard as of late about funding shock — from the FSOC to Fed Governor Tarullo (see yesterday’s post here), we can’t help but think this paper is serving as the intellectual backbone behind a lot of it…to say nothing of the shape of regulation to come.
The paper takes in interesting look at liquidation timing.
Calculating the number of days it would take to sell off a hypothetical portfolio of 0 billion (the sample size of a large dealer’s tri-party financing book), they find it could range, based on typically traded volumes, between 9 days for US Treasuries and Strips to 30 days for ABS. Overlaying Va R to that process results in some idea for the magnitude of losses that could be incurred.
The paper outlines some suggestions for dealing with pre- and post-default liquidation. The authors suggest that an agreement between dealers to form a consortium to buy out government paper from the cash lenders (should there be a dealer default) could mitigate the risk of a fire sale.
We wonder how that would work and if it isn’t just passing the hot potato?
By this (we think) they mean, among other things, remarkably static tri-party haircuts across a variety of asset classes while the financial crisis was swirling around them and lack of granularity in tri-party schedules that allowed for some volatile paper to slip in under the asset-backed category. Mitigating the dealer-side risk could be longer dated financing, thus reducing the vulnerability that comes with maturity transformation (especially on less liquid collateral)..
Much of this has been fixed or is in process of being corrected. And finally the authors noted that capital and liquidity regulation could play a part to reduce dealer vulnerability.
Another concept mentioned was a repo resolution authority with the power to claw back losses (from liquidation).
Finally, “an ex post emergency central bank liquidity backstop for the dealer’s creditors” was examined.
Operationally speaking, selling large amounts of paper inherited in a default may simply be impossible without some serious outside help.
Squeezing down the unwind/rewind period means that cash lenders have collateral risk for more of the day – ultimately trending toward 24 hours less “an operational moment in time”.
While it reduces the clearing bank’s risk, it increases the cash lenders’.