Nomura: US Downgrade May Cause Repo Market Liquidity Freeze

Tired of all the lies that a US downgrade will have no impact whatsoever on unsecured funding be it money markets, repo or so many other shadow banking system components (full list is below)? So are we. Which is why we were very interested to read the following summary of a Nomura research report that a US downgrade "may cause a repo liquidity freeze." Remember the Ice-9 in money markets following Lehman? Well, it may not be quite as big as money markets (last at $2.7 trillion), but at $1.3 trillion, frozen Repos will certainly cause a lot of headaches, especially with a dramatic scarcity of short-term Bills available in the market place for replacement capital flow. For all those wondering why the Fed and the BIS have been writing paper after paper (here, here and here) warning about the potential complications arising from the shadow banking system, this is precisely the reason.

From Nomura, as summarized by Bloomberg:

  • Risk of U.S. downgrade and default may have more impact than the lack of debt ceiling resolution - may cause repo market liquidity to freeze and “keep money markets in risk aversion mode,” Nomura strategists led by George Goncalves write in note.
  • “A default scenario will severely disrupt the repo market by increasing haircuts, causing dislocations between securities with and without defaulted coupons and potentially freeze up repo liquidity all together”
  • A downgrade won’t “trigger forced selling” in money market funds since 2a-7 rules define any U.S. government securities as “first tier”: Nomura
  • Money funds may choose to reduce exposure to U.S.
  • Treasuries that could be “at risk of missing coupons in case of default”: Nomura

And here is a graphic breakdown of all the shadow banking system components. These are precisely where all the adverse side effects will be concentrated as soon as the headlines hit that the US is no longer AAA.

Those wishing to learn more are urged to read the following presentation from the FRBNY which in addition to manipulating capital markets makes pretty presentations.

Shadow Banking Fed