Treasury Holds Auction to Avert Breakdown in 'Repo' Market
By GREG IP and GREGORY ZUCKERMAN
Staff Reporters of THE WALL STREET JOURNAL
October 5, 2001
The U.S. Treasury Department Thursday took the unprecedented move of holding an unscheduled auction of 10-year Treasury notes. to avert a breakdown in a little-known but critical part of the financial markets.
The department decided in the morning to sell the $6 billion in 10-year notes, six weeks before the regular quarterly refunding. A shortage of specific Treasury issues since the Sept. 11 terrorist attacks was making it progressively more difficult for a market in short-term lending, known as the "repo" market, to function normally. It was the first unscheduled sale of bonds since regular auctions began in 1977.
"The repo market is the core of our nation's money markets," said Peter Fisher, the Treasury Department's undersecretary for domestic finance. "It's important for the Treasury to contribute to trying to clear up these problems ... that appear to be compounding." While the White House and Congress are working on a fiscal-stimulus package for the economy that may force the government into a deficit for the first time since 1997, Mr. Fisher said the auction had nothing to do with the government's borrowing needs.
Nonetheless, the sudden arrival of new supply sent the price of the 10-year note falling 7/32, or $2.1875 per $1,000 face amount, to 103 28/32. The yield rose 0.027 percentage point to 4.508% after reaching a three-year low of 4.44% earlier. The 30-year bond rose 2/32 to yield 5.309%.
The problems appeared to be easing Thursday, but the crisis is an example of the sort of "systemic risk" for which regulators are always on the alert, when problems with one market segment or participant cascade through the broader markets, causing widespread disruption.
While the repo-market problem pales compared with previous crises, such as the near-failure of hedge fund Long-Term Capital Management in 1998, it still shows how a shock to the system such as the Sept. 11 attacks can disrupt the financial markets in unpredictable ways.
In a repo, securities dealers or other market participants will borrow money, typically for one to seven days, and pledge securities as collateral. They take back, or "repurchase," the securities (thus the name "repo") at the end of the loan. Bond dealers, who quote prices at which they will buy and sell bonds, depend on the repo market -- estimated at $500 billion a day -- to finance their positions.
A series of events following the Sept. 11 attacks have caused a shortage of the two-, five- and 10-year Treasurys, among the most popular and widely accepted forms of collateral. That has left some participants unable to return the securities on time, causing the transaction to "fail." Fear of failed trades in turn prompted some holders of the bonds, in particular foreign central banks, to refuse to lend them out, exacerbating the shortage. The Treasury's impromptu bond sale was aimed both at alleviating the immediate shortage and beating back the self-perpetuating psychology that was exacerbating the problems.
"The fail situation has been incredibly acute," said Paul Thomas, who runs Merrill Lynch's government-bond-trading business. "The concern is if we continue to have fails people won't be willing to lend their securities, and the longer the problems exist they will feed on themselves."
One of the first triggers for the repo market's problems was that many bonds were tied up in unsettled trades at the Bank of New York, a major clearing bank whose facilities in lower Manhattan were disrupted by the attacks.
Then, when the stock market plunged promptly after reopening on Sept. 17, many investors scrambled to load up on the "safe haven" securities, said David Greenlaw, an economist at Morgan Stanley. Many were nontraditional Treasury investors who didn't want to lend their bonds. As mortgage rates fell, triggering a wave of mortgage refinancings, many owners of mortgage-backed securities were being repaid prematurely, prompting some investors to load up on longer-term Treasury bonds as a substitute, said Michael Ryan, fixed-income strategist at UBS Warburg.
Failed trades are common, but during the weeks after the attacks they cascaded as one dealer failed to deliver bonds to another who as a result failed to deliver them to yet another.
Weekly cumulative transactions that "failed to deliver" among the Federal Reserve Bank of New York's 25 primary dealers averaged $45 billion for the second quarter. It reached $400 billion for the week ended Sept. 12, $1.4 trillion for the week ended Sept. 19, then dropped to $800 billion for the week ended Sept. 26. These figures, a Fed spokesman cautioned, "have little market or economic significance. For the most part they are merely delays in processing."
Still, the repo market's problems have begun to impair regular trading of Treasury bonds, Mr. Greenlaw said. It has gotten harder to make normal-size trades at the prices dealers were quoting, he said.
"Mr. Fisher and Treasury made a pretty bold and decisive move," said Eric Foster, an executive at the Bond Market Association trade group. Mr. Foster noted, however, that it won't be until at least Friday when there are indications whether settlement issues have eased.
The degree of the shortage is evident from the "repo" rate charged on loans to someone willing to provide the coveted five- or 10-year issues as collateral. Those rates, as low as 1% before the attacks, dropped to zero for overnight loans and 0.35% for longer-term loans during recent days. After Thursday's auction, the overnight rate remained close to zero but longer-term repo rates popped back up to 0.7%. "There was a significant impact on the market," said Kevin Fitzpatrick, a repo trader at Merrill Lynch.
The Treasury Department announced Thursday's auction after a conference call with the Treasury Borrowing Advisory Committee, made up of private-sector market participants.
But the Treasury Department, the Federal Reserve Bank of New York and the Securities and Exchange Commission have been monitoring the repo market since problems began cropping up after the attacks. The Fed has tried to help by boosting loans from its own portfolio of Treasurys.
Mr. Fisher said the Treasury Department had hoped the shortage would ease after the quarter ended Sept. 30, and when it didn't, decided to act.
While some traders said new five-year issues also were needed, Mr. Fisher said, "We thought we would start with the 10-year and see if this works." One option, if the shortages persist, is for the department to conduct its own repo program, in effect issuing bonds and buying them back a few days later. Treasury Department officials said how much Thursday's auction affects the regular quarterly refunding will be decided as that event approaches. They said some of the issues sold Thursday likely would have to be bought back some time in the future, to avoid having too many mature on the same day.
Treasurys
Treasurys ended mixed, after drawing early strength from news that a Russian jet heading from Israel to Siberia crashed.
The news fanned fears of another terrorist attack and prompted expectations of flight by investors to the relative safety of the government-securities market.
The Treasury sold an additional $6 billion of its 10-year issue maturing Aug. 15, 2011, adding to the $11 billion outstanding. The auction was designed to provide more of the maturity to the overnight-repurchase-agreement market, which has been plagued by incomplete transactions since the Sept. 11 terrorist attacks.
Convertible Bonds
Convertible-bond issuance resumed for the first time since the Sept. 11 terrorist attacks with issues from Electronic Data Systems Corp. and Province Healthcare Co.
In addition, a long-delayed $225 million issue by Brinker International Inc., was expected shortly.
EDS sold $752 million of zero-coupon, contingent convertible securities with a yield-to-maturity of 1.25%. The company's stock price must rise 20% before conversion into common shares is possible and by 35% before investors could convert the securities into shares at a profit.
Despite those limits, which some viewed as restrictive, the deal was said to be 10 times oversubscribed.
Province's $150 million of notes had a 4.25% coupon and conversion premium of 27%. Province, of Brentwood, Tenn., owns or leases general acute-care hospitals and provides hospital-management services.
REOPENED 10-YEAR NOTES
Here are results of Thursday's reopened auction of 10-year Treasury notes. All bids are awarded at a single price at the market-clearing yield. Rates are determined by the difference between that price and the face value.
Applications $14,175,225,000
Accepted bids $6,000,038,000
Bids at market-clearing yld accepted 53.57%
Accepted noncompetitively $225,000
Accepted frgn noncomp $0
Auction price (Rate) 103.783 (4.519%)
Interest rate 5.00%
Cusip number 9128277B2
The notes are dated Aug. 15, 2001, and mature Aug 15, 2011.
In other credit markets:
Around $1 billion hit the investment-grade corporate bond market as investors reported a stabilizing of secondary spreads.
Mortgage-backed securities put in a stellar performance, as the surprise Treasury auction brought Treasury yields higher and somewhat eased prepayment fears.
Electricite de France's 800 million euros 15-year benchmark were priced to give a spread of 0.43 percentage point over comparable French government bonds. In Asia, Japanese government bonds traded mixed. |
