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32. Does repo ‘encumber’ a borrower’s assets?
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If a borrower pledges collateral to a lender, legal title to the assets remains with the borrower, unless and until he defaults on the loan. As a result, the assets are said to have been “encumbered” by the legal interest in the asset given to the lender. This means that, in the event of a default by the borrower, his unsecured creditors cannot benefit from the liquidation of these assets.

Repo involves an outright sale of assets for cash. It therefore does not encumber a borrower’s assets any more than any other outright sale of assets. In return for the asset, the borrower receives cash, a generally superior asset in terms of credit and liquidity risk.

The argument that repo entirely encumbers assets is illusory. Consider a bank with cash assets of 10 funded with liabilities in the form of 5 of equity and 5 of unsecured deposits. Assume it uses the cash to buy bonds worth 10. It then repos out the bonds for cash of 10. On its balance sheet, it now has 20 of assets in the form of 10 in bonds and 10 in cash and 20 of liabilities in the form of 5 of equity, 5 of unsecured deposits and 10 of repo debt. Assume the bank then uses the borrowed cash to buy 10 more in bonds, so that it has 20 of assets in the form of 20 in bonds and 20 of liabilities in the same form as before. The encumbrance argument would say that 10 of the bond assets are encumbered because they are held as collateral by the repo counterparty. However, in the event of a default by the bank, these assets would be netted off against the 10 in cash owed to the repo counterparty. This would leave the bank with the same 10 of assets (in the form of bonds) that it had at the start to cover the 5 of unsecured deposits. The bank’s unsecured depositors are as well protected as before, even though the encumbrance ratio has risen from zero to 50%.

Those unfamiliar with repo are sometimes misled by its accounting treatment. Assets sold as collateral in a repo remain on the balance sheet of the seller, even though legal title to those assets has been transferred. This could give the appearance that the assets would be available to other creditors in the event of default. The collateral does not leave the balance sheet of the seller because he is committed to buy back the collateral at a fixed price at the end of the repo, which means that he retains the risk and return on the collateral (if the market price of the collateral falls during the repo, the seller has to buy back at a loss, and vice versa). Balance sheets are intended to measure the economic substance of transactions, not the legal form. If collateral was moved off the balance sheet of the seller, it would unhelpfully disguise his leverage (this is what Lehman Brothers and MF Global did). Under International Financial Reporting Standards (IFRS), assets sold as collateral are distinguished from other assets, so the situation is clearly explained to investors (see question 37).

The one occasion on which repos can encumber assets is when there is a haircut or initial margin imposed on the collateral (in addition, potential margin calls can be seen as contingent asset encumbrance). However, this is marginal encumbrance. And, in practice, haircuts and initial margins have been used selectively in the European market. Ironically, official proposals for a minimum mandatory haircut on collateral may make encumbrance a more material issue.


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