Will A Downgrade Cause A Funding Crisis?

• The Financial Times – Short-term US funding highly restricted Conditions in the short-term US funding market remained highly constrained on Monday, with a key financing rate for Treasuries climbing to its highest level in 11 months, as investors awaited key votes on raising the federal debt ceiling. Although a deal to raise the $14,300bn debt ceiling was set to pass later in the US day, signs of relief in the short-term funding markets were hamstrung by settlement of last week’s $99bn in new Treasury paper, which pushed more debt into the market.

The so-called general collateral rate for the overnight financing of Treasuries in the repurchase or “repo” market shot up to 40 basis points, matching the high set at the end of last September, and averaged 32bps in trading on Monday before closing at 20bps according to Newedge. The volatile spike in repo financing reflects a combination of money market funds not lending their cash, which normally soaks up excess Treasury paper, oversupply of which was being exacerbated by the settlement of new securities. “When there is more collateral in the system, general collateral spikes,” said Scott Skyrm, senior vice-president at Newedge. “The question is whether a debt ceiling deal results in retail accounts returning to the repo market or will they stay away.” Ira Jersey, strategist at Credit Suisse, said: “Once a debt ceiling deal is done, rates should ease, but there is a lot of cash out there, with money market funds still worried about possible redemptions.”

• The Wall Street Journal – Debt Ceiling’s Overlooked Flash Crash
Markets were remarkably unmoved by Washington’s political theater over the debt ceiling. The fall in stocks was limited. Any bounce from this weekend’s deal was quickly overshadowed Monday by more bad news on the U.S. economy. But, in an obscure corner of the stock market, investors did get a reminder of the risks still lurking in the system—in particular, Wall Street’s popular practice of depending heavily on short-term funding to finance long-term investments. At the height of the debt-ceiling uncertainty on Friday, a handful of mortgage real-estate investment trusts suffered a mini flash crash. Shares of Annaly Capital Management plummeted 19% in a few minutes in the morning, and American Capital Agency fell 22% before recovering the lost ground. The two REITs invest in government-backed mortgage securities using huge amounts of short-term debt. The quick selloff was said to be induced by stop-loss orders that many investors place on these shares, which trigger a sale if the share price moves a certain amount. The big fear for the companies has always been a spike in interest rates. That could create a double whammy, hitting the value of the REITs’ long-dated mortgage securities, while also raising the cost of financing their short-term debt pile. But the root of Friday’s panic actually came from a different source. Investors suddenly worried that REITs would lose access to the debt market they rely on for funding. Typically, REITs use repos, or repurchase agreements, getting leverage by pledging their government-mortgage securities as collateral.

Comment:

As we detailed previously, the funding markets continue to come under stress because a potential downgrade is looming. A potential downgrade matters!

The first chart below shows the overnight general collateral repo rate. At 33 basis points (bps) it is at a two-year high.

The second chart shows the the effective funds rate. It closed at 17bps yesterday, its highest level since February. Today it is at 22bps. If this level holds, it also marks a two-year high.

The third chart shows the daily standard deviation of the effective funds rate as published by the New York Federal Reserve. It is a measure of volatility in the funds market. Yesterday it was 0.08%, also a two-year high.

The last two charts show overnight and 3-month LIBOR. They are moving up as well.

So what does this all mean?

• The street continues to be at a negative carry position. Financing is too expensive for anything out to two years. The dealers must be screaming. Will the Federal Reserve respond (QE2.75)?

• With rates and volatility spiking, volume is going to disappear (if it has not already).

If these bullet points are correct, this might be signalling the start of a funding crisis. The debt deal is not enough to prevent a downgrade and the funding markets have agreements that say transactions must use AAA securities as collateral and all deals must be cleared through AAA institutions. The bottom line is few, if any, really understand what a downgrade means for the funding markets.

Click on chart for larger image

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