Repurchase Agreement - Risks

Risks

While classic repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold, at the maturity date. In other words, the repo seller defaults on his obligation. Consequently, the buyer may keep the security, and liquidate the security to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this risk, repos often are over-collateralized as well as being subject to daily mark-to-market margining (i.e., if the collateral falls in value, a margin call can be triggered asking the borrower to post extra securities). Conversely, if the value of the security rises there is a credit risk for the borrower in that the creditor may not sell them back. If this is considered to be a risk, then the borrower may negotiate a repo which is under-collateralized.

Credit risk associated with repo is subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc.

Certain forms of repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco in 2005. Occasionally, a party involved in a repo transaction may not have a specific bond at the end of the repo contract. This may cause a string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument. The focus of the media attention centers on attempts to mitigate these failures.

In 2008, attention was drawn to a form known as repo 105 following the Lehman collapse, as it was alleged that repo 105s had been used as an accounting trick to hide Lehman's worsening financial health. Another controversial form of repurchase order is the "internal repo" which first came to prominence in 2005. In 2011 it was speculated, though not proven, that internal repos used to finance risky trades in sovereign European bonds may have been the mechanism by which MF Global lost some several hundred million dollars of client funds, before its bankruptcy in October 2011.