$128.9 Billion of Failed Treasury Transactions last week......and My friend "Harvey" ...

....at 4:30 ET today the New York Fed released that figure.  $128.9 Billion isn't a lot of money in the grand scheme of things....but when it involves Wall Street's elite being unable to deliver collateral it merits at least some discussion.  $128.9 Billion last week (30% of transaction volume), $170 Billion per week in September (35% of transaction volume).  Hmmmmm......So let's try to figure out what the heck is going on.

I have to say, as I was paging through the New York Fed's weekly transaction data, as I know many of you, my loyal readers, often do, my focus was a bit less laser-like than usual.  Oddly enough, as riveting as the data was, my mind begin to wander.  I found myself daydreaming about the "good old days" as an undergraduate at the University of Wisconsin.

I recalled a wonderful young man, who, to protect his identity, I'll simply refer to as Harvey.  (Author's note: I chose Harvey as his alias only because there have been a couple of  relatively destructive Harveys in the news lately and the moniker seemed apropos.)  

Harvey, as I recall, was an affable, energetic, athletic, intelligent young man.  He could hold his own in conversations on just about any topic.  He was a big-man-on-campus and the life of the party.  Everyone knew Harvey. Sadly, as you might suspect from this preamble, Harvey had a bit of a dark side.  Whenever we went out to the local college bars, as University of Wisconsin students have occasionally been known to do, Harvey would always hit me up for a loan.

Harvey: "Hey....do me a solid, I left my wallet back at the dorm.....give me $20.00....I'll catch you next time."

Me: "What?....again?  You always do this! ....and you never pay me back."

Harvey: "Don't worry man I'm good for it.....I wanna buy a round of Kamakaze's for those hotties over there....you can be my wing man."

Me: "Jeeezzzz.....and you are going to pay me back this time??....."

Harvey: "Promise man.....and I'll make it up to you for all the other crap I've pulled."

Me: "Ok....but you better pay me back......here's the $20...."

Of course, these exchanges went on through the semester.  Whenever I tried to collect from a sober Harvey during the week the conversations usually went something like this.

Me:  "Hey do you have that $20 I gave you Saturday night?"
Harvey: "Sorry man...I've been swamped...classes are tough...my finance professor is a pain in the ass...I'll make it up to you....you have my word."
Me: "Come on Harvey....you've been giving me one excuse after another...."
Harvey: "Really man...it's not my fault....a couple of guys owe me money and they won't pay me back....as soon as they pay me I'll pay you...."

Finally, one night when Harvey was drunk at the Red Shed I cut him off....no more money for old Harvey.  His outburst went something like this:

Harvey:  "Who the F@c% do you think you are?  I never borrowed any money from you.....you throw your money around, piss it away drinking and now you expect me to bail you out?  F@c% you a-hole....you are nothing......you think you've got friends on this campus?  Do ya?....Your name is shit on this campus....now get the F@c% out of here....loser..."    

Harvey eventually graduated and got a job working at one of the big banks.  I'm not sure whatever happened to him but I'd guess he's doing just fine.  As far as I could tell, he had all of the personal qualities and demeanor that would make him a great banker/trader.....but I digress...where was I?....Oh, right.....Treasury/Repo fails.....let's continue.

So....What's a Repo?

Let me take one (1) quick paragraph to explain what goes on at the New York Federal Reserve Bank every day.  A good sized chunk of the worlds collateral and cash passes through the books.  Keep in mind, nothing actually moves.  747's full of cash, bonds and T-bills aren't flying all over the globe. The New York Fed keeps the score card.  That said, a "Repo" is exactly what it sounds like.  If I run a financial institution and I need cash, and you run another institution and you have cash, I can sell you Treasury Securities (Bonds/Bills) and you send me money.  I also agree to "Repurchase" the Securities from you at a later date, sometimes tomorrow (Overnight Repo) or some other agreed upon date.  In other words, I'm borrowing money from you using my T-Bills/Bonds as collateral.  It's a short term loan.  Of course, you'd be entitled to the interest on the securities (collateral) for the days they are on your books. 

Commentary: There are only two (job related) things you can be fired for as a money manager.
1.) Losing money on your dumb-ass (hindsight is always 20/20) investments. 2.) Letting money sit idle. Un-invested cash is a hot potato.....gotta earn some interest!

So as a money manager, you've got to keep your money safe and working.  Treasury securities are the collateral of choice (although other securities are also/often used) as Repo collateral.  (There are markets for Government Agency Securities, Mortgage Backed Securities, Corporate Debt, Junk, Derivatives, etc.)  For the purposes of this discussion we'll just focus on Treasury Securities.

In the last year, roughly US$25.9 Trillion of US Treasury transactions were handled by the New York Fed.  Despite this market's enormity, only the creme de la creme of the world's global financiers are allowed to play in this sand box.  There are 23 "Primary Dealers" who are the gate keepers of this vast marketplace.  If you manage money and want to participate in the Repo Market these are the only businesses who will grant you access.  Based on the financial pedigree of the folks involved, the quality of the collateral and the technology deployed, you'd think that these transactions would almost never fail to close.  However, interestingly enough, they fail often....and sometimes in surprisingly large waves (like the recent trend).  In the words of a crotchety old banker friend of mine, while commenting on a post-dot-com-bubble Repo failure....

"They can't pay??......These things should be good as gold!.... What the hell??."

So.....How Many Transactions Fail?

The New York Fed publishes weekly, summary transaction and failure data, which I've presented in graphic form below.  The following represents "Delivery" transaction failures compared to completed US Treasury Transactions since 2006.  Each 52 week period is shown as of the end of the September Quarter.  

A couple of things jump out.  First we note the huge failure rates in 2008 (US$15.9 Trillion) and 2009 (US$14.3 Trillion) or 51.6% and 68.3% of transaction volume respectively.  We also see that Delivery Failures (FTD) normalized in 2010, creeping up to 14.5% by 2015 and nearly doubling again in 2016 to just over 26%.  Perhaps the chart below illustrates the situation a little clearer.

So it looks like failure rates of transactions, that historically shouldn't fail, have increased to the highest rate since 2006 (Except, of course, for the financial crisis, which I'm trying to block out....I guess that's why they call it a "crisis").  Note: After the financial crisis, to "incentive-ize" the players to complete transactions, the Fed, in 2009, adopted a dynamic "fails" charge, intended to penalize the failing party at a rate roughly equivalent to 3% (annualized) of the transaction value.  This "fails charge" and (some well placed post-Lehman caution) is the primary reason fails dropped to 4% in 2010 and remained in the 5% range through 2012.  This makes perfect sense, a 3% "fine" in a near-ZIRP environment is a whopping penalty.  These are supposed the be "risk free" short term/overnight loans.  As a money manager, you'd be incompetent if you were routinely paying 3% for money, when you should only be paying 1% for it.  Fails charges are the equivalent of paying late fees on your credit cards or getting pay-day loans....the cost is so onerous that the only reason you'd incur them is that you are backed into a corner and have no other alternative. 

Well, to parse the phenomenon a little differently, let's dig a little deeper into the recent quarterly numbers.

When we examine the quarterly figures, the increase in failure activity jumps off the page.  Moreover, the failure rate in September of 2017 (most recent month) came in at 34.8%.  Bankers and Traders suddenly seem to be Ok with paying lots of "fail" charges.  This, obviously, is worrisome.

Further, the highest weekly failure rates in the last 52 weeks occurred in September of 2017.  (40.9% September 6th; 40.4% September 20th and 31.5% September 13th)  Quarterly Window Dressing perhaps?  Hard to tell....

So now we've established that Repo failures have increased significantly over the years, generally increasing in Q3 & Q4, but nowhere near the levels of the financial crisis.  Again, it looks like the game has changed dramatically since 2010. 

So Why Do These Transactions Fail?

Much has been written about the mechanics of failed transactions.  I've posted a few links below if your interested, but suffice it to say that the transaction failures we're discussing in the above charts, generally, have only a few root causes.

1. There's an error, the wrong securities/terms/dates etc. are recorded and the counter-parties disagree at settlement date.  There's a process for reconciling these transactions, but nevertheless, the are reported as "fails".  (Author's Note:  Not a problem.)
2. Computer/clearing/system problems.  I don't believe that there's a business in America that hasn't blamed their IT department for transaction and/or back office issues at one point or another.  The New York Fed is apparently no different.  (Author's Note:  Not a big problem.  The NY Fed's IT Department is pretty good.)
3. "Failing" on a transaction provides a greater benefit (or lower cost) than delivering/receiving the Securities as agreed.  i.e.) The banker can get a better return somewhere else, so it makes sense to "fail".  (Author's Note:  Actually, this shouldn't be that big of a problem since the implementation of the "fails" charge.) 
4. Credit/Counter-Party Risk:  One of the Counter-Parties can't fulfill their end of the deal.  (Author's Note:  Big problem.  Because the Counter-Parties are actually willing to pay the fails charges, there's a good chance that this is the genesis of the recent wave of fails.  I'll refer to this as a 'Harvey Fail' later on in this post.)  

Let's look at the mechanics of "failing".  Each of the twenty three (23) Primary Dealers listed above will handle transactions for their own account as well as for their customers. 

1. When a transaction fails, it's reported as a failure for every business day after the initial failure.  i.e.) If a US$100 Million transaction fails, and is not settled (delivered/received) for five (5) days for any reason, it's reported as a $1 Billion failure.  ($100 Million "Failure To Deliver" (FTD) and $100 Million "Failure To Receive" (FTR) x 5 days)  Since FTD is nearly 100% correlated to FTR over time, our discussion today will focus on Failures to Deliver (FTD).  
2. Once a transaction "fails" it may cause a "daisy chain", where other transactions depend on the completion of the failed transaction.  i.e.) Dealer A fails to deliver $100 Million in securities to Dealer B; Dealer B had already agreed to sell these securities to Dealer C; and Dealer C has agreed to sell the securities to Dealer D.  Unless one of the Dealers purchases/borrows the Securities somewhere else, to complete their end of the transaction(s), the "fail to deliver" reported will be $300 Million (A+B+C) rather than just the $100 Million. 
3. A "Round Robin" would occur if, in the above example, Dealer D had agreed to Sell the Securities to Dealer A.  In other words, the entire transaction could fail because Dealer A made a commitment to deliver the same securities it was expecting to receive from Dealer D, to Dealer B.  Because of the opacity of the transaction, Dealer A would have no way of knowing that these were actually the same securities.  I'll go into this in more detail in a diagram below.  Is your head spinning yet?.....just wait....there's more.
4. The lower the interest rate, the lower the "cost" of failing becomes.  The inherent cost of failing is, of course, the time value of money.  At near-ZIRP the "cost" of failing is comparatively low. We could spend some time talking about the perverse impact that negative-interest-rates (where the borrower is actually paid to borrow) have on Repos but I'll save that for another post.  Author's Note: As previously mentioned, Post-Lehman, the TMPG (NY Fed - Treasury Market Practice Group) imposed "failure fees" or "fines" for failing to complete transactions, the equivalent of an annualized minimum interest rate of 3%.  I'd argue that today's failure rates, because of the Counter-Party's apparent willingness to absorb these "costs of failing" are even more worrisome than the Lehman/Bear days when there was no additional imputed cost to fail.  
5. When transaction fail rates accelerate, it's not uncommon for Dealers to temporarily withdraw, or at least become a little more selective, while they reassess what's going on with their counter-parties, causing other counter-parties to follow suit, increasing the probability of  "fails".  There's a good chance this is happening now, we just don't know who's clamping down on who.  If unabated, Credit Markets can "freeze up", as we saw first hand only a few short, disturbing years ago.   
6. Do you recall "Rehypothecation"? I first discussed this phenomenon in August of 2015 (Don't Worry....Be Happy...)  Because of Rehypothecation, under certain conditions, it may actually be mathematically impossible to close out all of the transactions.  In theory, we could run into a  situation where, on any given day, there may not be enough collateral in existence.  
7. As we learned from Lehman, Bear, et al.  Counter-parties really have no idea what's going on with the other side of the trade.  (Authors Note: They think they do....but they don't.)  Dealer A might think they are dealing with Dealer B, but in reality, their transaction may be dependent  on a counter-party of Dealer D.  The only documents these bankers have in their "files" is a collection of really nice letterhead evidencing stellar reputations and long time personal relationships, some financial statements and a rock-solid commitment to deliver a chunk of really good collateral (or cash) that may or may not be available from some other counter-party....but if, and only if, they can't make more money somewhere else. Most Dealers have no idea that some 26 year old, consequence impaired, Wharton wizard is churning & burning the other side of their trade to make some big, fat commissions/bonuses....even though their 26 year old traders are doing the exact same thing.   
8. Again, keep in mind that this post ONLY addresses Treasury Security Transactions.  These Securities are the Cadillac (I think that's still a compliment) of collateral, traded by the best, smartest, most talented and heavily capitalized financial businesses in the world.  I'll repeat what my crotchety old banker friend said......"these transactions should NEVER fail!"  Yet, our financial system actually seems designed to facilitate and manage these fails.  The system perpetuates the opacity of these Primary Dealers and their clients. i.e.) We have no idea who's really trading these enormous sums and what their real financial commitments are.  The informal practice of "rolling over" these fails, for a fee/fine until they are actually cleared, at least to me, is also cause for concern since all of these transactions take place in a vacuum. If my favorite underwriting "rule of thumb" holds true, 5% of the culprits are causing 90% of the problems. It would be nice to know who these players are, before we have a Lehman-esque redux.

Rehypothecation

As you may recall, I mentioned the impact of Rehypothecation on the potential availability of securities in a prior post.  For those who need a quick refresher on what in the wide world Rehypothecation actually is, I'll describe it with a little story starring my good friend Harvey.  Rehypothecation is a fancy-schmancy financial term for "reusing" collateral.

Let's say that Harvey is the president of the local Frat House.  His Frat was, for various disturbing reasons, evicted from their last house.  Harvey needed to find new digs.  He quickly located a perfect house to rent from a wonderful, trusting, naive landlord.  Harvey, with all the charm he could muster,  offered to sign a ten year lease, and pay a little more rent than the landlord was asking, as long as he could occasionally put a mortgage on the property (even though he didn't own it).  For some inexplicable reason, the wonderful, naive, trusting landlord agreed.

Harvey signed the lease and immediately went out and put a half dozen mortgages, each for full collateral value, on the property.  Harvey was "Rehypothecating" or "reusing" the collateral, even though he didn't own it.   Oddly enough, none of the mortgage lenders ever asked if Harvey had put any other mortgages on the house (collateral) or whether he even owned it.  They just loaned him the money.  The loan applications didn't ask about any other encumbrances and the mortgage terms didn't prohibit any other mortgages on the property.  There were also no provisions in the loan documents as to what Harvey could (or couldn't) do with the money.  So Harvey got cash he could invest equal to six (6) times the value of the new Frat house.  Since interest rates were really low he could easily make the mortgage payments out of principal.  Harvey figured, since he was a finance student, majoring in probability and game theory, he would fly to Vegas with is new found stake and put his education to work at the tables.  Hopefully, everything would work out, Harvey would make a killing (he was brilliant), pay back all of the mortgages, pay the rent on time and throw the biggest, loudest Toga Party the University of Wisconsin had ever seen......or, if by some remote chance things didn't go all that well in Vegas, no matter what, Harvey absolutely knew that things would somehow work out.  Harvey was an incredible optimist.

Of course the above sounds absolutely absurd and would be a textbook example of lender incompetence at best and perhaps mortgage fraud at worst.  But, unfortunately, the sophisticated investor's version of the above happens every day at the New York Fed.

Let's expand my example above with Dealer(s) A, B, C, D & E as a "Round Robin" and throw in a couple of Rehypothecations as well, with Dealer H (Harvey), just to see what the impact might be on Treasury "Fails".  For illustration, let's assume the following:

1.) Each transaction is for $100 million.
2.) Each Dealer agrees to sell Securities today and buy them back tomorrow.
3.) These are the only transactions the dealer is entering into that day.  (i.e. no other cash or Securities are available)
4.) The red arrows represent the flow of cash and the black arrows represent the flow of securities.

Ok, I know the above looks like a convoluted mess, but I assure you, it's intentional.  That's what I'm trying to illustrate.  Can you imagine trying to diagram the $25 Trillion in annual transactions?  When we examine the above we see that:

1.) None of the Dealers (A,B,C,D &E) actually have any skin in the game.  They all have made commitments to deliver collateral to each other based on the commitment of the others. If all of the transactions complete (i.e.) a Dealer in the chain actually provides collateral/securities), the Fed would report five, $100 million transactions, yet there would be no change in the Securities Balance or the Cash Balance of any of the Dealers.

2.) If every dealer chooses to wait until they receive their securities from the prior Dealer in the chain before fulfilling their commitment, all transactions will fail.  They will continue to fail until someone in the chain steps up to provide collateral.  No completed transactions would be reported and $500 million in both FTD and FTR fails would be reported per day.

3.) Dealer Harvey, located overseas (e.g. Lehman's London Rehypothecation gambit), in a jurisdiction which has no limits on Rehypothecation, receives permission (for a fee) to Rehypothecate from his Client H. Dealer Harvey gets all five Dealers (A,B,C,D & E) to provide cash totaling  $500 million by re-using Client H's $100 million (Frat house) as collateral.  All five Dealers believe they've have fully secured/collateralized Repos when in reality, they have little/no title/right/standing re: the pledged collateral, adding potentially unlimited leverage to the system.

5.) In the above example, when Client H Repurchases his collateral, Dealer Harvey must either locate another client willing to allow him to Rehypothecate, or replace the collateral with $500 million in securities, rather than the $100 million as he had been using under the Rehypothecation.

6.) Again, all of these clandestine transactions take place in secrecy.   None of the dealers involved are aware of the commitments or available securities at the other dealers, yet all of the transactions are related. The butterfly is flapping its wings at Dealer A and typhoons form at Dealer E.  From the Dealer's perspective it looks like hundreds of millions dollars of collateral and cash are changing hands.  The markets look liquid, yet there's little/no underlying collateral....just empty promises to deliver it. Again, there could come a time where there is simply not enough collateral available at any price to close the transactions. It will become tougher and tougher to keep all the balls in the air. Perhaps, and I'm just guessing here, that's why we're seeing the failure rates inch up over the last few years.  Dealers have no choice but to juggle and pay the "fines".



Harvey Fails & The Dick Fuld Banker-Speak Translator (BST)

Given the above, I'd be remiss if I didn't take the time to deploy our patented BST to try to explain how Harvey Fails eventually get put to rest. Here's a hypothetical Repo Fail discussion between a Banker I'll call Lucky Dan and my favorite banker..... Harvey....

Lucky Dan: "Harvey, what's going on?... we've been waiting for you to close your position for two days.  Can I get a timeline?"

Harvey: "Dan, I've been meaning to call you, market conditions are becoming quite difficult.  Not to get into detail, but we're trying to work our way out of a couple of illiquid positions.  We just need a little more time.  Don't worry, it's just a short term imbalance."
Harvey (BST): "Don't worry man I'm good for it.....I wanna buy a round of Kamakaze's for those hotties over there....you can be my wing man."   

Lucky Dan: "Can you give me a little more color on the transactions?  Maybe I can help you work through it....."

Harvey:  "Not to worry old friend.  It's all good.  Just do me a favor.....We should be able to close everything out by Thursday.  I just need Morgan and Goldman to come through.  It's all good...."
Harvey (BST): "Really man...it's not my fault....a couple of guys owe me money and they won't pay me back....as soon as they pay me I'll pay you...."

FRIDAY

Lucky Dan: "Harvey, we've got to shut you down, you're well past terms, I'm sorry...it's out of my hands."

Harvey:  "I fully understand, I'd do the same thing if I were in your position.  We've got some solid alternatives.....don't worry, we'll get this resolved.  Let's get lunch next week."
Harvey (BST):  "Who the F@c% do you think you are?  I never borrowed any money from you.....you throw your money around, piss it away drinking and now you expect me to bail you out?  F@c% you a-hole....you are nothing......you think you've got friends in this town?  Do ya?....You're name is shit ....now get the F@c% out of here....loser..."   


Final Thoughts.....

Here's my thesis:  We're deluding ourselves....what we really have is a financial system fraught with an epidemic of uncollateralized loans backed solely by the reputation of the borrower.....for whatever that's worth.....masquerading as loans secured by US Treasury Bills/Bonds.  There's no transparency when money is moving at the speed of light.  When multiple parties lay claim to the same collateral on a systemic basis what good is it?  If multiple parties commit to deliver securities that don't exist, based on other commitments that can't be mathematically fulfilled, what do we really have?... Especially when we only find out that these claims exist after the fact, when things go South and the they have to be unwound.  Even the greatest financial wizards lose their mystical powers if they're not sure what's lurking behind the curtain.

These increased fails charges are yet another "behind the curtain" canary in a coal mine.  The Fed's Balance Sheet "Normalization" (aka buying bonds) will only exacerbate the condition.  As the collateral pool shrinks, collateral will be more difficult (and expensive) to locate.  Failure's and the inherent transaction cost will increase.  Let's just hope that I'm dead wrong and we're dealing with temporary imbalances and matching problems (that's what Harvey would tell you) rather than systemic credit risk.

Not to worry though, per Janet Yellen in her August 25th, Jackson Hole speech, everything is fine and dandy.  GDP is chugging along, Employment is steady, our asset prices (stocks, houses, etc.) are all up big since 2009!  We are much safer than we were ten years ago. We've put substantial controls in place to prevent what happened in 1929, 1987, 1999 and 2009, from ever happening again.  The Fed has done an awesome job!

To pose a rhetorical Question: Have you ever heard any banker say that "today my bank is less profitable and has gotten much riskier, less safe, less liquid and our underwriting guidelines have gone to hell-in-a-hand-basket on my watch"??  They (according to them) are the smartest guys in the room.....why inconvenience everyone with things like the Volker Rule, Dodd Frank and other cumbersome, unnecessary regulations......Laissez-faire for all!.......just sayin'.....

My final rhetorical question.....Why does it take you, me and "Joe Lunch-Box" two months, bales of documents, ten years of income verification and a cavity search to get a $300,000 mortgage (Which is subsequently securitized, sold to a hedge fund and used anonymously as Rehypothecated collateral ) when we have Quadrillions of dollars (FICC) flying around the globe in nano-seconds with absolutely no idea who's sending it, receiving it and why they're doing so?  ....and why in the world, would these titans of finance be unable to close these "risk free" transactions?

As my crotchety old banker friend often said:

"This is bullshit..."


Author's Note:  Dear Readers: I'll be traveling for a couple of weeks with occasional spotty Internet access (Rural India.....I love India....the whole crazy, wonderful place helps me think about things I wouldn't normally think about), so if you are trying to reach me, please allow a little more time for me to respond.  Namaste'.


Additional Reading:

Atlanta FRB - re-Hypothecation discussion.
https://www.frbatlanta.org/news/conferences-and-events/conferences/2016/0501-financial-markets-conference/videos/research-session-1-collateral-rehypothecation-efficiency.aspx

NY Fed - Fails Charges
https://www.newyorkfed.org/medialibrary/microsites/tmpg/files/Fails-Charge-Trading-Practice-2016-07-13.pdf

Janet Yellen's Speech - August 25th, Jackson Hole - Everything is just fine....
https://www.federalreserve.gov/newsevents/speech/yellen20170825a.htm

TMPG - Fails Charges - 2010
https://www.newyorkfed.org/medialibrary/media/research/epr/10v16n2/1010garb.pdf

TMPG - Fails Charge Docs
https://www.newyorkfed.org/TMPG/settlement_fails.html

A favor
https://www.youtube.com/watch?v=DTtpWgrhS78

New York Fed - Primary Dealers
https://www.newyorkfed.org/markets/primarydealers

New York Fed - Primary Dealer Transaction Statistics
https://www.newyorkfed.org/markets/gsds/search.html#

Financial Times - Repos
https://www.ft.com/content/97ff6658-d87b-11e0-8f0a-00144feabdc0

WSJ - Repos
https://www.wsj.com/articles/repo-failures-at-highest-levels-since-2008-1458580656

ICMA Group
https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/40-what-happens-to-repo-transactions-when-interest-rates-go-negative/

https://deep-throat-ipo.blogspot.com/2016/02/window-dressing.html

New York Fed -  Bangladesh Cyber-Heist
http://www.reuters.com/investigates/special-report/cyber-heist-federal/