Many repo borrowers faced a tough choice when the economy ground to a halt in March. Spurred by Covid-driven market headwinds, their repo lenders issued margin calls for additional collateral.
But many lenders wrongfully insisted that those calls could only be satisfied with cash or cash-equivalent securities. The threat of immediate default forced many borrowers to liquidate healthy assets at fire sale prices and suffer significant losses as a result. However, those losses may be recoverable insofar as the lenders’ unilateral demands violated the parties’ agreements.
Repos, or repurchase agreements, are a prominent feature of the global financial system. They are often used by institutional investors to obtain short-term financing from large financial institutions and bulge bracket banks.
The repo lender buys a basket of securities subject to an agreement by the repo borrower to later repurchase those securities at a premium. The premium is the interest on the loan, and the securities serve as collateral while the loan is outstanding.
Although repos have historically been viewed as relatively safe, one of the risks is that the collateral is marked to market. If the market value of the collateral declines, the repo lender typically has the right to issue a margin call—i.e., demand that the borrower post additional collateral. If the borrower fails to do so, the lender can immediately declare a default, seize and liquidate all of the borrower’s collateral, and seek any shortfall from the borrower.
A Nightmare Scenario Under Covid-19
A nightmare scenario unfolded during the Covid-induced market dislocation in March. As federal and state governments imposed lockdowns to control the spread of the disease, economic activity—and asset prices—suffered a drastic decline. Faced with economic uncertainty and falling asset prices, firms of all types and sizes rushed to build up their cash reserves. For their part, lenders issued margin calls to their counterparties.
In the repo space, many of the margin calls came with a brutal wrinkle. The lenders insisted that additional collateral take the form of cash or cash-like securities, like Treasuries. Because a repo default could trigger cross-defaults in other transactions and cause a run on the borrower by counterparties and investors, many borrowers had no choice but to liquidate their unencumbered assets to come up with the cash.
This meant selling securities at depressed prices at the lowest depths of the market panic at significant losses—indeed, according to publicly available data, the REIT industry alone lost hundreds of millions of dollars during that time. Although markets stabilized at the end of March due to the federal government’s intervention, the forced sales foreclosed any opportunity to take advantage of the ensuing rebound in asset prices.
Those losses may nevertheless be recoverable through legal means because the lenders’ sudden demand for cash or cash-like collateral may have breached the parties’ contracts.
Like ISDA agreements for derivative transactions, repo agreements are largely standardized, with most based on the form repo agreement published by the Securities Industry and Financial Markets Association (SIFMA).
The form repo agreement does not permit lenders to insist on a specific type of collateral to satisfy margin calls. To the contrary, the form repo agreement gives the borrower the option—aptly referred to as the seller’s option—to decide the type of collateral to post in response to a margin call. In other words, the borrower, not the lender, decides if the margin call will be satisfied with cash or securities.
What’s more, the lender also does not decide what kind of securities the borrower can post as additional collateral. The form repo agreement provides that the securities used to satisfy a margin call should be the same securities (or assets) as already used by the parties in their repo transaction.
So if the parties used mortgage-backed bonds as collateral in their repo, the borrower has the right to post more of those bonds to satisfy the lender’s margin call. These provisions protect investors from immediate market losses by allowing them to post assets, rather than force-selling them for cash, until asset prices can recover.
By denying repo borrowers the opportunity to use the seller’s option, repo lenders may have violated their agreements. They did so at a time when borrowers were at their most vulnerable and at a pace that was very difficult to prevent even by resorting to requests for immediate injunctive relief.
As their balance sheets continue to stabilize, repo borrowers victimized by these tactics should consider seeking to recover their losses. Insofar as the terms of their repo agreements mirror the form repo agreement, the law may be on their side.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Uri Itkin is a partner in the New York office of Kasowitz Benson Torres. He specializes in litigation involving structured finance, complex financial products, and real estate transactions.
Drew Grossman is an associate in the New York office of Kasowitz Benson Torres. His practice focuses on complex financial and commercial litigation.