UPDATE 1-New York Fed threatens new rules to stop repo-market fire sales

Thu Feb 13, 2014 2:54pm EST

By Jonathan Spicer and Dan Burns

NEW YORK Feb 13 (Reuters) - The banks and big funds in a key short-term funding market have not even begun to address the risk of destabilizing "fire sales," and the lack of action may force regulators to step in with new rules, the Federal Reserve Bank of New York warned on Thursday.

The market for so-called tri-party repurchases, or repos, is at particular risk of seizing up entirely, as it did in the 2008 financial crisis, if a big player defaults, the New York Fed said. It added investors are "highly vulnerable" to liquidity pressures and credit losses that could force them to dump collateral in a fire sale.

The stern warning from the branch of the U.S. central bank suggested regulators are growing frustrated with the lack of industry action to fix a problem that was at the heart of the financial crisis more than five years ago.

The New York Fed, which is tasked with overseeing the Fed's open market operations, said no mechanism currently exists or is being developed by the banks and funds in the tri-party market to ensure that investors will act collectively and in a measured way in liquidating their collateral.

"As noted by Federal Reserve Bank of New York President (William) Dudley in a recent speech, in the absence of a market-based solution to this risk issue, regulators may be forced to use the tools they have to take steps to reduce this risk," the bank said in a statement.

"Fire sale risk remains a critical policy concern of the Federal Reserve and other members of the U.S. regulatory community."

In repurchase agreements lenders, such as money funds, make short-term loans to banks or other borrowers and receive collateral such as Treasuries or other bonds. Banks then often make similar loans to far more leveraged investors such as hedge funds.

A fire sale can happen when a dealer comes under stress and dumps assets in a bid to shore up its liquidity, depressing asset values that hurt other firms then have to sell in an accelerating chain.

Worries over a fire sale of collateral against repos at Long Term Capital Management (LTCM) when it almost defaulted in 1998 led to a group of banks having to purchase the fund and then slowly unwind the firm. Then in September 2008, the repo market rapidly dried up when investment bank Lehman Brothers failed.

The two clearing banks for tri-party transactions, JP Morgan Chase & Co and Bank of New York Mellon, have adjusted systems in the last two years to reduce the use of intra-day credit, but the New York Fed said little has been done to better manage risk.

The regulator made that recommendation two years ago; in October, Dudley said government agencies may need to intervene.

While it is unclear what the Fed and other U.S. market regulators could do, the threat of new rules has alarmed members of a European capital markets association, which worries the Americans will adopt an ill-suited solution.

Fed Governor Jeremy Stein said in October that regulators have tools they can employ to help shore up liquidity at individual companies such as banks, including risk-based capital, liquidity and leverage requirements. He noted, however, that none are a comprehensive solution to the problem of repo market fire sales.