Foreign banks use US repo deals to ‘window-dress’ risk

foreign banks

Foreign banks operating in the US short-term debt markets are “window-dressing” their accounts, routinely cutting about $170bn of balances at the end of each quarter to appear safer and more profitable, says a new study.

The study from the Washington, DC-based Office of Financial Research describes a pattern of behaviour that has prevailed since July 2008, and suggests that the banks are carrying more risk than their investors or customers can easily see.

The study examines the vast market for repurchase agreements, or “repos,” where banks lend out assets in return for short-term financing. It finds that dealers sell heavily to customers in the last days of the quarter, and immediately buy assets back once the new quarter starts. By trimming their balance-sheets over that brief period, the foreign banks can report better quarter-end ratios of capital to total assets.

US banks, which have to report average daily balances over the quarter, do not make similar adjustments, the study found.

“This abrupt, seasonal rhythm . . . is consistent with a pattern of ‘window-dressing,’” wrote Greg Feldberg, acting deputy director for research and analysis at the OFR, in a blog post.

Analysts said the behaviour outlined in the study has shades of the notorious “Repo 105” trades that Lehman Brothers used to bring down its reported leverage in the quarters leading up to its collapse. In that programme, the broker accepted a relatively high 5 per cent fee in order to count its repo transactions as true sales, even though it remained under a contractual obligation to buy the assets back.

Joshua Ronen, a professor of accounting at New York University’s Stern School of Business said the OFR’s study — which did not cite individual banks by name — showed that lenders with the lowest capital ratios were making the biggest quarter-end reductions.

Deutsche Bank, Credit Suisse and Barclays — three of the biggest foreign players in the US repo markets — declined to comment on the study.

One bank pointed out that foreign banks will have to adopt US-style daily leverage reporting requirements by January 2018, and that many had already begun to adjust their repo activities to comply with daily averaging — including reducing the absolute amounts and quarter-end adjustments.

For now, though, outsiders should take the banks’ reported ratios with a pinch of salt, said Mayra Rodriguez Valladares of MRV Associates, a former official at the Federal Reserve Bank of New York.

“If they’re moving assets around to look better it is a big problem for us, as we don’t get to see the day-to-day information,” she said.

“If something adverse happens, we could have been lulled into a false sense of security that [the banks] are sufficiently capitalised.”

  • Ben McLannahan in New York
  • (This story is on Page 16 of the 11/2/15 Financial Times paper edition, however the headline is different: “Foreign groups accused over repo deals”)

Government research warns of quarterly dumping by foreign banks

NEW YORK — A government research paper says foreign-owned broker-dealers are dumping an average of $170 billion in certain U.S. assets before the end of each quarter in order to appear safer and less levered.

The practice, driven by an effort to comply with overseas regulatory requirements, could hurt U.S. money market funds, as well as bond investors, according to the report by the Office of Financial Research (OFR), a unit of the Treasury Department.

The report, written for OFR by Benjamin Munyan of Vanderbilt University, is based on confidential regulatory data from the OFR and the Federal Reserve.

The paper concludes that broker-dealers with foreign parent companies are collectively dumping certain short-term borrowings by an average of $170 billion at the end of each quarter to better meet capital requirements, which are measured at the end of each quarter.

The report calls this practice “window-dressing,” and says no such practice was found by U.S. banks because U.S. banking regulators use a quarter-average measure of leverage ratios.

But the dumping — of an asset known as re purchase agreements, or repos — could affect U.S. money market funds and Treasury investors, the paper warned.

Repo agreements are a form of borrowing — usually overnight — that are a major source of liquidity for money-markets funds and institutional investors.

JPMorgan CEO Jamie Dimon and former Treasury Secretary Larry Summers have both warned of a liquidity problem that some experts have said could be linked to declines in repo funding.

The OFR paper said the selling by foreign banks could affect prices for U.S. Treasuries and other government bonds, which are a major form of collateral in the repo market.

The quarterly selling may also leave money market mutual funds with excess cash they cannot invest.

Despite being able to anticipate quarterly window dressing, money market fund manager were unable to find any investment for about $20 billion of cash each quarter-end before September 2013, the paper said.

The Federal Reserve’s reverse repurchase agreement program began at that time as a substitute investment for repo lenders during times of window dressing.

‘Fear Index’ Grabs Headlines as Stocks Swing: Volatility gauge yields clues on how investors are insuring their portfolios

When Robert E. Whaley settles into his home office, you can count on two things: His television will be tuned to CNBC, and he’ll be tracking the stock market’s “fear index” on his computer.

Mr. Whaley, a professor of finance at Vanderbilt University, may not be a household name. But chances are you’ve heard of the volatility index he designed, known to market watchers as the VIX.

The VIX is the most popular measure of expected short-term volatility on Wall Street. The index is computed in real time on trading days, and when it shoots up, it suggests investors fear market prices are about to move wildly.

The historical average of the VIX is around 20. Lower numbers signal that investors are confident in the strength of their investments. Higher numbers signal investor anxiety. For example, during the 2008 financial crisis, the index hit a dizzying 80, and last month, it made news when it spiked above 50 for the first time since 2009 before returning to near its long-run average.

“What you’re scared of is a drop in the value of your pension fund,” said Mr. Whaley. “The higher the VIX gets, the more fear you have the market will drop.”

The VIX reflects investors’ sentiment by tracking how much they are paying for “out-of-the-money” stock options—particularly “put” options, which provide a cushion against falling market prices.

Mr. Whaley compared it to buying insurance for a beach house.

“If a hurricane is forming and there is potential for the hurricane to hit land in the next few weeks, you are likely to pay a whole lot for insurance,” he said. “You want to protect the value of the home.”

If investors fear a storm is brewing in the stock market, they could sell their stock, but with trading fees and other costs that would be expensive. Or they could opt to protect their investment.

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“Instead of selling your stocks, you can go out and buy insurance, and the insurance you would buy would be put options on the S&P 500.” Mr. Whaley said.

A “put” option gives someone the right to sell stock at an agreed-upon price by a certain date. The stock price specified in the contract is called the “strike” price. And if it is lower than the market value of the underlying stock, the options are “out of the money.” (A “call” option is the opposite; it gives someone the right to buy stock at an agreed-upon price by a certain date.)

“VIX is driven by the price of out-of-money calls and puts, but the calls don’t really matter,” Mr. Whaley said. “If you look at trading activity in the market, it is predominantly puts. You’re only concerned about the downside risk.”

Put options benefit investors in the event that the market price of a stock tumbles below the strike price. If it does, the investor who bought the put will collect the difference between the two values.

For example, suppose the market price of the S&P 500 portfolio was $1,951 per share, and the strike price of a put option was $1,950. If the market price falls below that threshold to, say, $1,945 before the option contract expires, the investor who purchased the put will collect $5 per share. (This doesn’t account for the cost to purchase the put option.)

If the market price doesn’t fall below the strike price before the contract expires, there is no payout.

“If the stock stays above $1,950, you’d have a situation you have with any insurance,” Mr. Whaley said. “You pay for it and never collect. You lose the premium. What you bought is the satisfaction that if there had been a drop, you would have been covered.”

Options contracts are sold by market makers who accept risk to facilitate trading. The fees they charge for the options contracts offset their own risk of having to pay off investors if the stocks do tank. So when nervous investors begin to clamor for puts, market makers raise the price.

That is what sends the VIX skyward.

“The more demand, the higher the price, and the higher the prices, the higher the VIX,” Mr. Whaley said.

Investment firms like Zacks notice the VIX, but because they look further into the future, the level of the fear gauge doesn’t alter their overall strategy, according to Bryant Sheehy, who is business development director for Zacks.

“It’s more of a way to add some sexiness to editorial articles,” he said, referring to headline-grabbing shifts in the VIX. “It’s one more data point we can mention to talk about a tough market and what opportunities are now coming up.

But for speculators—the storm chasers of the stock market—the VIX serves as a weather vane, pointing out when they should plunge into the market in search of short-term trading profits.

“Volatility is opportunity, not risk,” said Tim West, who publishes market analysis on, a social network for investors and traders. “Most people get that backwards.”