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Investor alert: repo agreements.

GFOA's Subcommittee on Investments, made up of members from GFOA's Standing Committee on Cash Management, is preparing an update to Considerations for Governments in Developing a Master Repurchase Agreement, Second Edition (GFOA 1988) to address recent changes to The Bond Market Association's (TBMA, formerly known as the Public Securities Association) Master Repurchase Agreement. In the course of preparing this update, the subcommittee became aware that GFOA members were being contacted by their broker/dealers regarding changes to the accounting treatment for repurchase transactions under the Financial Accounting Standards Board (FASB) Statement 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."

Although governments may not be bound by FASB pronouncements, Statement 125 affects counterparties to repurchase transactions with governments and may change the nature of the underlying repurchase agreement from a buy-sell transaction to a collateralized loan. Treating repurchase transactions as collateralized loans would make them illegal for local governments in many states.

The Issue

The subcommittee has reviewed the matter, and advises investors to consider the following points.

In general, FASB 125 provides that if the transferee (i.e., repo buyer or the government entity) has the right to sell or repledge the securities under a repurchase agreement and the transferor (i.e., repo seller or the broker/dealer) does not have the right to substitute the securities or terminate the contract on short notice, the repo buyer will be required to record both the securities, together with any obligation to return the securities, on its balance sheet. The repo seller will be required to reclassify the securities from a securities inventory or investment account to a securities pledged account on its balance sheet.

As a result, and at the request of TBMA members active in the repurchase transaction markets, the Trading Practices Committee of the TBMA Funding Division published an optional substitution/termination provision to the TBMA Master Repurchase Agreement. The provision, if agreed to by the parties to the repurchase transaction, would allow the repo seller (broker/dealer) to retain effective control over the purchased securities. Or the repo seller could elect to terminate the transaction prior to maturity on short notice to the repo buyer (government entity) once the repo buyer has offered such an election to the repo seller (broker/dealer).

The language of the optional substitution/termination provision being presented to-governments appears below:

The parties hereto hereby agree to amend Section 9 of the Master Repurchase Agreement by adding at the end thereto the following paragraphs (c) and (d):

(c) In the case of any Transaction for which the Repurchase Date is other than the Business Day immediately following the Purchase Date and with respect to which Seller does not have any existing right to substitute substantially the same Securities for the Purchased Securities, Seller shall have the right, subject to the proviso to this sentence, upon notice to Buyer, which notice shall be given at or prior to 10:00 a.m. (New York time) on such Business Day, to substitute substantially the same Securities for any Purchased Securities; provided, however, that Buyer may elect, by the close of business on the Business Day notice is received, or by the close of the next Business Day if notice is given after 10:00 a.m. (New York time) on such day, not to accept such substitution. In the event such substitution is accepted by Buyer, such substitution shall be made by Seller's transfer to Buyer of such other Securities and Buyer's transfer to Seller of such Purchased Securities, and after substitution, the substituted Securities shall be deemed to be Purchased Securities. In the event Buyer elects not to accept such substitutions, Buyer shall offer Seller the right to terminate the Transaction.

(d) In the event Seller exercises its right to substitute or terminate under sub-paragraph (c), Seller shall be obligated to pay to Buyer, by the close of the Business Day of such substitution or termination, as the case may be, an amount equal to (A) Buyer's actual cost (including all fees, expenses and commissions) of (i) entering into replacement transactions; (ii) entering into or terminating hedge transactions; and/or (iii) terminating transactions or substituting securities in like transactions with third parties in connection with or as a result of such substitution or termination, and (B) to the extent Buyer determines not to enter into replacement transactions, the loss incurred by Buyer directly arising or resulting from such substitution or termination. The foregoing amounts shall be solely determined and calculated by Buyer in good faith.

Effects of the New Rule

In those jurisdictions where substitution of securities is permitted, entering into such an agreement may not be a problem. In fact, a loss provision is provided that is intended to place the repo buyer in the same position it would have been had the repo seller not exercised the substitution/termination right. This provision, of course, should be reviewed by legal counsel in order to assure no loss is incurred.

However, in those jurisdictions where substitution is restricted, the effect of the new rule may be troublesome dependent upon the relationship established with the broker/dealer, the jurisdiction's comptroller's position with respect to the change in accounting treatment of the transaction, and whether or not the government has the ability to avoid the restriction on substitution. In conclusion, legal guidance coupled with good business judgment will be needed in order to make the appropriate determinations in these jurisdictions.

Having participated in the GFOA Winter Meeting, the subcommittee is indeed hopeful that the update to the 1988 publication will be completed in time for its next meeting immediately preceding the association's annual conference in San Francisco. At that time, the subcommittee also will consider a recommended practice on this topic.

FASB Statement 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," (product code S125) is available for $11.50 each from the FASB Order Department, 401 Merritt 7, P.O. Box 5116, Norwalk, CT 06856-5116, or from the FASB home page at http://www.fasb.org.

RALPH J. MADALENA, Chief Financial Officer and Chief Operating Officer, New York State Housing Finance Agency and State of New York Mortgage Agency, is a member of GFOA's Committee on Cash Management. His opinions printed herein are entirely his own.
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Title Annotation:repurchase agreements
Author:Madalena, Ralph J.
Publication:Government Finance Review
Date:Jun 1, 1998
Words:1049
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