Let me be clear. We must deal with the fire sale issue in tri-party repo and the heightened run risk it creates. I believe there are three potential ways forward, all of which are superior to the status quo. First, tri-party repo transactions could be restricted to open market operations (OMO) eligible collateral.11 Such collateral would likely remain quite liquid during a time of crisis.12 In addition, such collateral could, in a crisis, potentially be passed directly by a broker-dealer to the discount window under Section 13.13 authority, or, because of beneficial treatment under Section 23A of the Federal Reserve Act, be financed by a banking affiliate that would then itself borrow at the discount window. Thus, one could construct an effective lender of last resort backstop for an OMO-eligible- only tri-party repo system. However, there are also some significant disadvantages to such an approach. The less liquid collateral could just migrate to be financed elsewhere, with associated run and fire sale risks. Also, given that housing finance reform could cause the agency debt and agency mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac to be replaced by something different that was not OMO eligible under the Federal Reserve Act, the share of assets that are OMO eligible could diminish over time. Finally, this approach would do little to mitigate the risk of fire sales of a defaulted dealer’s collateral by its investors once a dealer is bankrupt.
The securities in asset-backed commercial paper (ABCP) conduits serve as collateral for the issuance of asset-backed commercial paper, while repo conduits fund in the repo market. Most conduits are so-called single-seller conduits that only serve individual banks or finance companies. Multi-seller conduits provide funding for asset pools of multiple institutions. Conduits are backed by credit lines from commercial banks, which allow the conduits to have a credit rating. Asset-backed commercial paper conduits are also defined in “Shadow Banking: A Review of the Literature”. Federal Reserve Bank of New York Staff Reports, no. 580, (October) 2011. www.newyorkfed.org/research/staff_reports/sr580.pdf. 2  BIS central bankers’ speeches  Because the boom years resulted in strong earnings, low price volatility and few credit losses, firms were able to operate at extreme levels of leverage. When the housing bubble started to deflate, the vulnerabilities of this type of business model soon became apparent. Heavy reliance on short-term wholesale funding exposed the system to a series of intertwined downward spirals in asset and funding markets. This spread in waves, beginning in the market for asset-backed commercial paper (ABCP) issued by off-balance-sheet conduits, and spreading via auction-rate securities, to the repo, money market and financial commercial paper markets that formed the core financing for market-based financial intermediation. Initial declines in asset prices forced leveraged holders with maturity mismatches to sell assets. This increased price volatility and reduced the value of the assets that collateralized other firms’ borrowings.