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26. What happens to repo transactions in a default?
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If the defaulting party has documented its repo business under a master agreement, such as the ICMA’s Global Master Repurchase Agreement (GMRA), default means that the party has triggered one of the Events of Default listed in the agreement. In the GMRA, the standard list includes Acts of Insolvency such as the presentation of a petition for the winding-up of the party or the appointment of a liquidator or equivalent official. Other standard Events of Default are:
  • failures to pay cash amounts (such as purchase price, repurchase price and manufactured payments) or to meet margin calls;
  • making an admission in writing of one’s inability to meet debts as they fall due;
  • making materially incorrect or untrue representations;
  • being suspended or expelled from a securities exchange or (under the GMRA 2000) from another self-regulatory organisation;
  • being suspended for particular reasons from dealing in securities by an official body (a ‘government agency’ under the GMRA 2000 or ’Competent Authority’ under the GMRA 2011, the latter term being intended to include the innovative bodies established in the wake of the crisis such as resolution authorities);
  • (under the GMRA 2000) having assets transferred to a trustee by a regulator.
  • There is also a catch-all provision that failure to perform any other obligation is also an Event of Default if it is not remedied within 30 days of a notice being given of such failure. The parties can also elect to make failure to deliver collateral an Event of Default.
Under the GMRA, the occurrence of either of two of the Acts of Insolvency --- the filing of a petition for the winding-up of a party and the appointment of a liquidator or similar officer --- automatically puts the insolvent party into default (under the GMRA 2000, the precise moment is when the other party becomes aware of the event but under the GMRA 2011, it is when the event occurs). For all other Events of Default, a party is not actually in default until its counterparty serves a default notice.

Default notices must be served in writing in English. They can be delivered:
  • in person or by courier;
  • by registered mail;
  • by telex (but not under the GMRA 2011);
  • by fax;
  • in the form of an electronic message which is capable of reproduction in hard copy (this includes e-mail).
Default starts when letters are delivered, telexes prompt an answerback from the recipient: faxes are received by a responsible employee in legible form; registered mail is either delivered or delivery is attempted; or when an electronic message is delivered. However, for many of these methods, it can be difficult to prove that delivery has occurred. If the defaulting party refuses to accept delivery or is obstructive, and the non-defaulting party has made all practicable efforts to serve a notice using two of the methods listed in the agreement, the latter can draw up a Special Default Notice to be given to the defaulting party as soon as practicable. By signing such a notice, the non-defaulting party places his counterparty into default.

Once a party is formally in default, the process of close-out starts. This has three stages.
  • First, all outstanding obligations due on repos documented under the same GMRA are accelerated for immediate settlement and all margin held by the parties are called back.
  • Second, the Default Market Values of the collateral are fixed and transactions costs added. The non-defaulting party can also add the cost of replacing defaulted repos or, if he considers it reasonable, the cost of replacing or unwinding hedges.
  • Third, all sums are converted into the same currency (the one chosen as the Base Currency by the non-defaulting party when the GMRA was negotiated) and are netted off against each other to produce a single residual amount, which must be notified to the defaulting party. Whoever owes the residual sum must pay it by the next business day.
The speed of the valuation stage of the close-out process will depend upon the liquidity of the collateral assets. Valuation is under the control of the non-defaulting party. Under the GMRA 2000, he has five business days from the date of default to complete the valuation (although this can be extended in exceptional circumstances). He has a menu of three valuation options. If he buys or sells collateral, he can use the actual dealing prices. Or he can use market quotes, or a mix of dealing prices and market quotes, provided the quotes are from two or more market-makers or regular dealers in ‘commercially reasonable’ size. However, if the collateral is illiquid --- which means the non-defaulting party cannot buy or sell the collateral or, acting in good faith, he cannot find market quotes, or he can find quotes but he believes they are not ‘commercially reasonable’ (eg they are for amounts much smaller than needed) or would not be commercially reasonable to use --- he can estimate the Net Value of the collateral. This is a measure of their fair market value, calculated using whatever pricing sources and methods the non-defaulting party deems appropriate in his reasonable opinion. Sources can include, without limitation, securities with similar maturities, terms and credit characteristics. In effect, the calculation of Net Value is marking-to-model (calculating a theoretical fundamental price).

The non-defaulting party can charge interest on late payments but cannot use the close-out process to try to recover what are called consequential losses (with the exception of the cost of replacing repos or the cost of replacing or unwinding hedges). Consequently, downstream losses caused by the default (those not immediately due to the default on repos) cannot be claimed.

The default procedure in the GMRA was thoroughly tested by the default of Lehman Brothers in September 2008. It worked well and the netting of credit exposures under the GMRA and other standard master agreements (eg the Global Master Securities Lending Agreement and the ISDA Master Agreement) significantly mitigated the impact of crisis. Accordingly, the changes introduced by the GMRA 2011 were not substantial.

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