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Failure on hedge funds and money market funds in

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Unformatted text preview: failure on hedge funds and money market funds in particular, it is reasonable to assume that debt losses of the magnitude of the GSEs would have had far greater consequences and potentially triggered a run on the worst-hit firms, followed by a full-scale panic. 4.1.2 The Economy’s Plumbing About 250 feet below ground in New York City stand two large tunnels – one completed in 1917, the other in 1936. These tunnels carry over 1¼ billion gallons of water a day from mountain reservoirs that are located well north of the city. The problem is that they are leaking over 30 million gallons of water a day and are in desperate need of repair. Of course, the obvious solution would be to fix the leaks – in other words, to close the tunnel valves, enter the tunnels, and repair the damage. The problem is that if the valves are closed, engineers do not know for certain that they will be able to reopen them. And this would be catastrophic to New York: a loss of half of its water supply. It is no exaggeration to state that these two decaying tunnels provide 55 infrastructure without which the city could not function. It should be no surprise then that, in lieu of another solution, New York City is working feverishly 600 feet below ground on Tunnel no. 3, a $6 billion project that is slated to be completed by 2020, which will carry water and allow work on the other tunnels. It is simply a race against time. Similar to the giant tunnels under New York City, the financial sector also has become reliant on several institutions for its core “plumbing”. As one illustration, while many analysts focus on the systemic risk that is produced by the large dealer banks with their massive over- the-counter derivatives books and risky trading operations, regulators at the Federal Reserve Bank of New York (NY Fed) fret and worry about the Bank of New York Mellon (BNY). BNY – the oldest bank in the U.S., having been founded in 1784 by Alexander Hamilton no less – is certainly a large financial institution, and especially so in terms of custodial services and asset management. But this is not what worries the NY Fed. BNY is one of the two tri-party clearing banks – the other being JP Morgan Chase – for the repo market. As background, a repo is a secured loan in which one party borrows cash from another and pledges securities – U.S. Treasuries, Agencies, MBS, and other asset-backed securities – as collateral. However, repos backed by Treasuries, Agencies and MBS are technically “sale and repurchase” transactions in that the lenders can simply seize the underlying collateral in case of borrower’s default and remain exempt from any bankruptcy proceeding. Typical borrowers in repo markets are large financial institutions (“dealers”) and typical lenders are money-market funds and securities lenders (“cash investors”). They do not, however, execute their transactions directly with each other. Instead, BNY and JP Morgan Chase act as third parties in these transactions, providing intermediation services to the dealers and the cash investors. BNY and JP Morgan Chase, however, often provide a settlement of repo contracts to dealers...
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