Debt costs to rise as bank collateral re-use falls

NEW YORK (Reuters) - Corporate, mortgage and other debt issuers may be facing permanently higher costs as large banks face new restrictions on their use of client assets.

Banks have relied on their ability to reuse hundreds of billions of dollars in client assets that are posted against repurchase agreements, securities lending agreements and derivatives to back new trades and loans, boosting liquidity in many markets.

After losing assets when Lehman Brothers collapsed last September, however, many investors are forbidding banks to reuse the assets, a process known as rehypothecation.

Banks and investors have also restricted the collateral they accept to only the most liquid, highest quality debt, after many markets, including corporate bonds, froze in the aftermath of Lehman's failure.

As riskier debt is less acceptable for reuse, it will become more costly for banks to hold, which will hurt issuers.

"When securities are less available to freely circulate in the market, the liquidity of those securities goes down," said Darrell Duffie, professor of finance at Stanford University.

"Its going to raise the cost of trading in corporate bonds and will lower the attractiveness of buying corporate bonds when they're issued, and that means the corporation will have to pay a higher interest rate," he said.

A recent report by the International Monetary Fund estimates that the pullback in high grade collateral due to a reduction in the use of pledged client collateral and a pullback in securities lending and hoarding by banks, has adversely impacted global liquidity by around $5 trillion.

Large banks have reported significant declines in the number of securities they are able to reuse.

The amount of securities posted with Goldman Sachs (GS.N) against repos, securities lending agreements and derivatives that the bank was allowed to reuse fell to $596 billion in June 2009, from $891 billion in November 2007, according to the bank's quarterly reports.

Morgan Stanley (MS.N) saw an even larger drop, receiving $331 billion in June 2009 that could be repledged, compared with $948 billion in November 2007.

Securities lending by the major custodians including BNY Mellon (BK.N), State Street (STT.N) and JPMorgan (JPM.N) has fallen by half relative to its peak of about $1.6 trillion before the crisis, the IMF found.

Cash hoarding by major banks is also sizable with many large banks having around $200 billion each in cash or cash-equivalents, it said.

PRIMARY MARKET RALLY

Corporate bond issuance has surged in the past few weeks as issuers take advantage of a market rally, and banks also continue to be propped up by cheap government funds.

As government programs phase out, however, and banks need to rely on more costly, long term debt, their cost of carrying new bond issues will likely increase.

"Banks have access to cheap funds through government programs," said Joseph Abate, a money-market strategist at Barclays Capital in New York. "The question becomes when markets stabilize, will we go back to the traditional model of repo financing."

In a report before Lehman's collapse, Citigroup analyst Matt King found that reusable collateral posted against repos at large banks formed a large portion of their funding.

Morgan Stanley, for example, held $953 billion in collateral against repos that was available for reuse in May 2008, compared with $1.4 billion in assets held on its balance sheet, King found.

However, "its still much harder to repo corporate bonds or ABS than it was before the crisis broke out. That's probably a permanent adaptation and isn't really likely to go away now that people have an increased consciousness of the illiquidity of those markets," King said last week.

Without the benefits of collateral reuse, corporate debt may be unattractive to banks, leaving liquidity in the market in the hands of fund managers.

"Everybody has been absorbing lots of bonds in the primary market, but with the reduced size of bank balance sheets, there is a risk that if the buyside turn around and sells that volume of paper, there's almost no way in which it would get absorbed," said King.