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Why you should worry if the U.S. defaults

CommentaryThis commentary first appeared in the Santa Rosa (Calif.) Press Democrat.

As Congress once again threatens to default on U.S. debt, you are going to hear more predictions of doom. Should you be concerned?

Yes.

Let me explain this by going back to 2008.

That year, as home values tanked, the financial markets erupted into a full-blown crisis. This happened for the same reason that experts warn of disaster if the U.S. defaults on its debt: The repurchase market failed.

Many Americans have never heard of the repurchase market.

What is it?

Simple. It’s where giant financial institutions in the U.S. and Europe borrow $7 trillion from each other, every day, often just for overnight. $7 trillion. Every day. Just for overnight.

The main borrowers are the world’s biggest banks. They use this borrowed money to make investments and loans throughout our economy.

The main lenders are money market funds.

Other players are large mortgage companies, investment banks, corporations, insurance companies, pension plans, university endowments, municipalities and anyone with a big pool of money to lend.

If this market freezes, as it did in 2008 and might do again in the case of a U.S. default, the flow of credit throughout the country is dramatically impaired.

What can make the repurchase, or “repo,” market freeze?

That’s where mortgages and U.S. debt come in.

To get a repo loan, a financial institution has to put up some collateral, usually pools of mortgages or U.S. debt called Treasuries.

If the lender decides it doesn’t like the collateral, it won’t make the loan. Since repos are very short-term loans, often just for overnight, repo lending can stop on a dime and the repurchase market can freeze in a matter of days.

That’s what happened in September 2008. Repo lenders lost faith in the mortgages they’d been taking as repo collateral. They stopped lending. Giant financial institutions could not get money.

Federal Reserve Chairman Ben Bernanke told Congress that in September and October of 2008 “out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.”

This is what turned a real estate bubble into the worst financial crisis since the Great Depression.

Could it happen again, for example if lenders lose faith in Treasuries?

You bet.

If you’ve read this far, let me admit I’ve vastly oversimplified the repo story.

Interesting things happen on that market.

For example, collateral can be reused. If a borrower puts up $100 million in Treasuries as collateral for a repo loan, the repo lender can use those same Treasuries as collateral to get a repo loan for itself, and the next lender can use the same Treasuries as collateral to get a repo loan for itself.

Usually these are overnight loans that the lenders renew the next day. But imagine how interesting it gets when one of the lenders in the chain suddenly wants its money back.

Why is this market called the “repurchase” market? Because transactions take the legal structure of a sale and repurchase. The borrower “sells” its collateral to the lender and promises to “repurchase” it soon, often the next day.

The Fed conducts much of its monetary policy on this market. When you read that the Fed may sell the securities it bought during the recession, what the Fed will actually do is use those securities as collateral to get a repo loan. Then the lender to the Fed can use those same securities as collateral to get a loan for itself …. and so on.

Congress should not be messing with the repurchase market.

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2 responses to “Why you should worry if the U.S. defaults

  1. We are seeing a sell off in the ultra-short treasuries ( 1-mo bills) interest rates have moved from .01 earlier this month to .12 today. do you think this is a result of the pending debt ceiling crisis or is it an effect of the recent EM crisis. Short term treasury rates showed similar movement back in October during during the debt ceiling crisis we went through at that time.

    What are the effects on the repo market resulting from this kind of rate movement in short term treasuries.

    Thanks for a great site!

    • Hi, pjkar,

      Thanks for your interest in this stuff.

      I’m not smart enough to know which of the two issues might be causing a sell-off in ultra-short treasuries, but a sell-off in very short treasuries is one of the early signs of concern over the debt ceiling fracas.

      What are the effects of this on the repo market? In theory, lenders will demand more collateral. And that happens. But often lenders just exit the market, or so we’ve seen in the past. They choose to sit on the sidelines until the crisis passes. If prices get low enough, other buyers/lenders come in.

      For a more thorough discussion, I recommend “Debt Ceiling Crisis 2014″ by Scott Skyrm at http://www.scottskyrm.com and other columns by him. For daily reporting, keep your eye on FTAlphaville at http://www.ftalphaville.ft.com.

      Thanks for writing.

      Mary

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