Research by Boston Fed economist finds borrowers and lenders incentivized to take more risk
September 15, 2022 — In 2010, researcher Mattia Landoni obtained access to data on thousands of short-term loans known as “repos” that were issued in the three years before the 2007-2008 financial crisis. But like many of his colleagues, Landoni assumed that data on repos would be boring since they were generally thought of as safe. He did not take a closer look at it until 2014, at the urging of fellow researcher Jun Kyung Auh.
He quickly realized he was wrong: Repos were not boring. In fact, the lack of transparency into how they are made or how lenders manage risk has implications that could impact the economy’s fragility, said Landoni, now a senior financial economist at the Federal Reserve Bank of Boston.
“We need to understand what we are seeing here, or we could be just as blindsided by the next financial crisis as we were in 2007,” said Landoni, who works in the Bank’s Supervision, Regulation & Credit department.
Landoni and Auh teamed up on a paper that examines risk-taking associated with repos, “Loan Terms and Collateral: Evidence from the Bilateral Repo Market,” which is forthcoming in The Journal of Finance. The researchers find that repo loans against low-quality collateral are riskier than those against high-quality collateral. But they also find that there are incentives for both lenders and borrowers to continue engaging in these riskier loans.
The researchers said lenders appear to take more risk and receive more compensation when collateral quality is lower, and loans against low-quality collateral are cheaper for borrowers.
Quality, transparency of securities used as collateral varies widely
“Repo” is short for “repurchase agreement,” a short-term, collateral-backed loan. A “bilateral” repo is between two parties. The firm acting as the borrower agrees to sell securities – such as stocks and bonds – to another firm, and then repurchase those same securities at a higher price. The securities act as collateral, meaning the buyer keeps them if the seller breaks the agreement.
But the quality of the collateral varies widely. The researchers observed two main types of securities used as collateral: mortgage-backed securities and collateralized debt obligations.
Landoni said mortgage-backed securities have some degree of transparency because they are backed by real estate loans.
“You can list each mortgage by zip code, so you know exactly what is going into that (security),” he said.
Collateralized debt obligations are backed by a pool of loans and assets, and are, in theory, no more or less risky than mortgage-backed securities. But the researchers found that they are less transparent and more complex, making it harder to assess their value. And, Landoni said, “They were of lower quality, on average.”
Paper: Loans against lower-quality collateral are riskier, but attractive
For their paper, Landoni and Auh created a dataset of more than 13,000 “uncleared” repo loans – meaning they were made directly between two parties. The loans were made between a large hedge fund and major financial institutions from 2004-2007.
The length of the loans spanned one day to six months, and their principal amounts ranged from about $30,000 to more than $700 million, with a median of about $10.5 million.
The researchers analyzed the data and studied the prices of securities being used as collateral. They also created a model to determine what was causing patterns they observed in the dataset.
They found that, despite their higher margins, repo loans against lower-quality collateral were riskier than loans against higher-quality collateral. But both lenders and borrowers had incentives to engage in these riskier loans.
Why? The researchers said it relates to lender optimism and a behavior called “reaching for yield:” Lenders offer a relatively cheaper loan to a borrower with lower-quality collateral in exchange for the chance to take more risk and potentially earn more money.
Since borrowers can get cheaper loans using low-quality collateral, they have an incentive to continue buying it. And that gives the firms that produce securities used as low-quality collateral an incentive to keep creating them.
The researchers said it is critical to continue learning more about this market as the risks lenders take there could have significant impacts on the overall economy.
Landoni said efforts are ongoing to gather more information about the bilateral repo market. He added that he hopes the study helps inform a pilot program in the U.S. Treasury’s Office of Financial Research that is focused on establishing data collection and disclosure protocols.