Washington - The Federal Reserve Board of New York urged the U.S. Supreme Court to avoid defining the nature of a repurchase agreement, saying an overly broad interpretation could hurt the liquidity of this huge market.
The New York Fed's comments were made in a brief filed this week in Nebraska v. Loewenstein, which will be decided in the court's next term, which begins Oct. 3. The case involves Nebraska's taxation of income earned by John Loewenstein from his shares in mutual funds that invest in U.S. securities through repurchase agreements.
Many courts, the New York Fed said, have resolved the taxation issue by determining whether repurchase agreements, known as "repos," are secured loans or sales and repurchases. Income earned from secured loans is subject to state taxation.
The Nebraska Supreme Court struck down the state's tax because states cannot tax federal property under the Constitution. Taxing repos in effect taxes government securities, the court held. But the highest courts in six other states have upheld such taxation, mostly on the basis that repos are secured loans.
The New York Fed, which is not taking sides, said the case could be decided without characterizing repos because the issue is whether the state tax imposes an impermissible burden on federal obligations by diminishing their value.
In general, a repo is a contract for the sale or purchase of a security that is subject to a simultaneously created "forward agreement" for the repurchase or resale of the same or a similar security at an agreed date, the federal bank said.
The two-part transaction, viewed from the seller's side, consists of transferring specified securities by the seller to the buyer in exchange for cash. The second part is the seller's agreement at the time of the initial sale to repurchase the securities at the original price, plus an agreed upon amount of interest, at a future specified date.
A reverse repo refers to a similar transaction in which securities are bought subject to an agreement to resell, the bank said.
Municipalities, including school districts, actively participate in the government securities market through repos, but they can do so only if repos are not characterized as collateralized loans, the New York Fed said. Municipalities "are not empowered to make collateralized loans," and repos offer a way for them to earn interest in a short-term transaction with little or no risk of loss, the bank said.
"The repo transaction is extremely liquid because it can afford the holder of the securities the right of ownership ... Because a repo is not generally structured as a collaterized loan, the holder of the repo securities can sell the securities at will, subject only to the legal obligation to redeliver the securities of the same description on the forward settlement date," the New York Fed said.
"This liquidity feature has made repos the principal method of financing positions in government securities," the bank said, "In effect, repos allow a dealer to use its constantly changing inventory of government securities to finance its day-to-day operations, without losing any of the dynamism of the inventory."
Repos and reverse repos are a $1.5 trillion market, according to recent federal statistics, with more than $700 billion turning over every day, the New York Fed said.
"Repos are crucial to both the secondary and primary markets in government securities ... Dealers who underwrite new Treasury issues rely heavily on repos pending ultimate resale to investors," the bank said. By promoting liquidity and adding depth to the market, repos help lower interest rates on Treasury obligations, the bank said.
Because the repo market is supported by municipalities and other entities having charter or regulatory restrictions against making secured loans, any "general characterization of repos as secured loans could... jeopardize the continued participation of these investors in the repo market," thus depriving the market of depth and liquidity, the New York Fed said.
The bank also told the high court it is concerned about the Nebraska Supreme Court's reliance on inferences drawn from 1986 testimony in an unrelated case by Peter Sternlight, former executive vice president of the New York Fed.
The bank said it supported Sternlight's testimony, but emphasized that he did not address the economic effect of state taxation of income from repos on the underlying government securities, "which is the ultimate issue here." The state court's reliance on "inferences" from the testimony is "unwarranted," the bank said.
The State and Local Legal Center also filed a brief this week on behalf of the Council of State Governments, the National Conference of State Legislatures, the National League of Cities, and other state and local interests.
The brief supported the right of Nebraska to tax Loewenstein's income derived from repos. The tax does not consider the underlying federal obligation or interest paid on the obligation, the center said. Instead the tax considers the income earned in connection with a repurchase agreement, which "represents the value associated with the use of a sum of money for a given period of time," regardless of how the repo is characterized, the center said.
Moreover, the center said, there is no evidence that a state tax on repo income would diminish the market value of federal obligations.
