By Richard Comotto, Co-Founder and Chief Product Officer, London Reporting House
What would happen if you’re holding US Treasuries as collateral through a reverse repo and the US Treasury fails to make a coupon payment because of the debt ceiling?
A default by the issuer of collateral is not the same as your repo counterparty defaulting. It does not qualify as an event of default under the Global Master Repurchase Agreement (GMRA) so you cannot automatically terminate your agreement and all the outstanding repos documented under that agreement. Nor can you suspend the performance of your obligations under the condition precedent provision.
Nor under the standard GMRA, would the seller be required to substitute the defaulting collateral, although they could voluntarily agree to do so (although substitution might happen automatically if the repo was tri-party, depending on your collateral eligibility criteria).
Unless US Treasuries were to be restructured, the same issues have to be delivered back to the seller at maturity.
Assuming US Treasuries fall in value as a result of the default, under the standard GMRA, there would be two principal consequences for an outstanding repurchase transaction. First, the change in the market value of the collateral would allow a variation margin call or an increased variation margin to be made on the seller (by you) or reduce the variation margin call allowed on the buyer (you).
Second, the buyer (you) would not be obliged to make the manufactured payment to the seller that would normally be triggered by a coupon, given that the coupon has not been paid. Nor would there be the usual impact of a coupon payment on Net Exposure.
If the coupon were to be paid later but before the repo matured, the manufactured payment should happen then. But the seller would not be owed interest for the delay, because the obligation of the buyer (you) to make the manufactured payment is triggered by the coupon payment. If, on the other hand, the coupon were to be paid after the repo matured, it would go directly to the party who had been the seller as they would have regained title (although for bonds that go ex-div for more than the coupon date, which do not include US Treasuries, there could be a problem).
In the case of a buy/sell-back, the consequence for variation margin would be the same as for a repurchase transaction but, as manufactured payments do not happen in a sell/buy-back, the further consequences for the buyer and seller would be different from those in the case of a repurchase transaction. In a sell/buy-back, instead of compensating the seller with manufactured payments, the repurchase price is fixed at a discount to the normal repurchase price (which would be the sum of the purchase price plus repo interest). The default on the coupon does not change the repurchase price of a buy/sell-back. So, the seller would still only have to pay the discounted repurchase price to the buyer (you) at the maturity of the repo and they would therefore still be compensated for the coupon payment.
If the coupon were to be paid later but before the buy/sell-back matured, the buyer (you) would keep the coupon. However, you would be left out of pocket in respect of the lost time value. On the other hand, if the coupon were to be paid after the repo matured, it would be paid direct to the party who had been the seller and is now once again the legal owner. That would leave the former buyer (you) out of pocket for the whole coupon plus interest for the time value of the delay. Hopefully, the former seller would play nicely and pass the coupon back to the former buyer (you). But there seems to be a case here for an amendment to the Buy/Sell-Back Annex of the GMRA.
However, don’t take my word for it. Ask your lawyer.
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