"Repo has a flaw: It is vulnerable to panic, that is, 'depositors' may 'withdraw' their money at any time, forcing the system into massive deleveraging. We saw this over and over again with demand deposits in all of U.S. history prior to deposit insurance. This problem has not been addressed by the Dodd-Frank legislation. So, it could happen again." --Gary B. Gorton, Professor of Management and Finance, Yale School of Management (lifted from Repowatch)
Subprime mortgages did not cause the financial crisis, nor did the housing bubble or Lehman Brothers. The financial crisis originated in a corner of the shadow banking system called the repo market. That's where the bank run occurred that froze the secondary market, sent prices on mortgage-backed assets plunging, and pushed the financial system into a death spiral. In the Great Crash of 2008, repo was ground zero, the epicenter of the global catastrophe. As analyst David Weidner noted in the Wall Street Journal, "The repo market wasn't just a part of the meltdown. It was the meltdown."
Regrettably, the Federal Reserve's non-traditional monetary policies (ZIRP and QE) have succeeded in restoring the repo market to it's pre-crisis level of activity, but without implementing any of the changes that would have made the system safer. Repo is as vulnerable and crisis-prone today as it was when the French bank PNB Paribas stopped redemptions in its off-balance sheet operations in 2007 kicking off the tumultuous bank run that would eventually implode the entire system and push the economy into the deepest slump since the Great Depression. By failing to rein in repo, the Fed has ensured that financial crises will be a regular feature in the future occurring every 15 or 20 years as was the case before banks were more strictly regulated and government backstops were put in place. Repo returns us to Wild West "anything goes" banking.
Why would the Fed be so reckless and pave the way for another disaster? We'll get to that in a minute, but first, let's give a brief explanation of repo and how the system works.
Repo is short for repurchase agreement. The repo market is where primary dealers sell securities with an agreement for the seller to buy back the securities at a later date. This sounds more complicated than it is. What's really going on is the sellers (primary dealers) are getting short-term loans from money market funds, securities firms, banks, etc., in order to maintain a position in securities in which they're supposed to make markets. So, repo is like a loan that's secured with collateral. (i.e., -- the securities) It is a "funding mechanism."
What touched off the Crash of 2008, was the discovery that the collateral that was being used for repo funding was "toxic," that is, the securities were not Triple A after all, but subprime mortgage-backed gunk that would only fetch pennies on the dollar. So, when PNB Paribas stopped redemptions in its off-balance sheet operations on August 9, 2007, the rout began. Cash-heavy investors (like money markets) turned off the lending spigot, which reduced trillions of dollars of MBS to junk-status, precipitated massive fire sales of distressed assets that were dumped on the market pushing prices further and further down wiping out trillions in equity and reducing the financial system to a smoldering pile of rubble. That's why the Fed stepped in, back-stopped the system with explicit guarantees for both regulated and unregulated financial institutions and set about to reflate financial asset prices to their pre-crisis highs.
Newly appointed Fed chairman Janet Yellen summarized what happened in the panic in a speech she gave earlier this year. She said:
"The trigger for the acute phase of the financial crisis was the rapid unwinding of large amounts of short-term wholesale funding that had been made available to highly leveraged and/or maturity-transforming financial firms."
In other words, the crisis began in repo. Unfortunately, Wall Street has fended off all attempts to fix the system, because repo is a particularly lucrative area of activity. And we are talking serious money here, too. Tri-party repo alone -- which is a small subset of the larger repo market -- represents "about $1.6 trillion in outstanding repos daily." That means that the prospect of a big dealer dumping his portfolio of securities on the market at a moment's notice igniting another panic, is never far away.
Why do banks borrow in the unregulated, shadow system instead of conducting their business in the light of day where regulators can check the quality of the underlying collateral, oversee the various transactions on public trading platforms, and make sure that capital requirements are maintained?
It's because the banks want to deploy all their capital, leverage up to their eyeballs and play fast-and-loose with the rules. Here's what the New York Fed has to say on the topic:
"One clear motivation for intermediation outside of the traditional banking system is for private actors to evade regulation and taxes. The academic literature documents that motivation explains part of the growth and collapse of shadow banking over the past decade...
"Regulation typically forces private actors to do something which they would otherwise not do: pay taxes to the official sector, disclose additional information to investors, or hold more capital against financial exposures. Financial activity which has been re-structured to avoid taxes, disclosure, and/or capital requirements, is referred to as arbitrage activity." ("Shadow Bank Monitoring," Federal Reserve Bank of New York Staff Reports, September, 2013)
In other words, the banks are conducting their operations in the shadows because it's cheaper. That's what this is all about. Here's more from the same report:
"While the fundamental reason for commercial bank runs is the sequential servicing constraint, for shadow banks the effective constraint is the presence of fire sale externalities. In a run, shadow banking entities have to sell assets at a discount, which depresses market pricing. This provides incentives to withdraw funding -- before other shadow banking depositors arrive."
Okay, so when there's a run on the local bank, the bank may have to off-load some of its illiquid assets (real estate, commercial property, etc.) to meet the increased demand of depositors who want their money, but they can also rely on government backing (deposit insurance). But with shadow banking -- like repo -- it's a bit different; the problem is fire sales. For example, when repo lenders -- like the big money markets -- demanded more collateral from the banks in exchange for short-term funding; the banks were forced to dump more of their assets en masse pushing prices lower, eroding their equity and leaving many of the banks deep in the red. This is how the panic wiped out Wall Street and cleared the way for the $700 TARP bailout. It all started in repo.
The point is, had the system been adequately regulated with the appropriate safeguards in place, there would have been no fire sales, no panic, and no crisis. Regulators would have made sure that the underlying collateral was legit, that is, they would have made sure that the subprime borrowers were creditworthy and able to repay their loans. They would have made sure that repo borrowers (the banks) had sufficient capital to meet redemptions if problems arose. And regulators would have limited excessive leveraging of the securitized assets.
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