Road to Ruin

For newcomers to the repurchase market, it’s best to first read the About Repo tab on the RepoWatch home page.

 April 7, 2011 (last updated: December 1,  2012)

Securitized banking, which is the name that Yale economist Gary Gorton has given to the combination of repurchase agreements and securitization, was the witches’ brew that erupted in 2007 and 2008.

But financial institutions have been repo-ing and securitizing for years. What changed in the 21st Century, to make securitized banking so lethal?

Between 1999 and 2005, regulators took a series of steps to make it easier and more profitable for financial institutions to borrow money with collateral created by securitization. This was the debt that nearly paralyzed the financial markets in 2008.

The steps do not include two congressional acts often accused of causing the crisis – the Gramm-Leach-Bliley Act of 1999, which overturned parts of the Glass-Steagall Act, and the Commodity Futures Modernization Act of 2000, which prohibited regulation of derivatives. See the end of this article for a further discussion of these two acts, which deeply impacted the financial markets but did not contribute directly to the crisis.

The fatal steps were:

1999

(1) Fed switched to tri-party repo: The Fed made a fateful decision that helped set up the financial markets for the 2008 disaster.  It began using tri-party repo to implement monetary policy, after almost a century of using bilateral repo. This change concentrated financial-market risk at the Bank of New York and JP Morgan. Federal Reserve officials Ben Bernanke and Tim Geithner have said this was their main concern in 2008, and it’s a problem that still exists today. Further, as long as the Fed is dependent on tri-party repo, it’s hard to see how the Fed can impartially regulate that market or its players.

2000

(2) FASB Statement 140: The Financial Accounting Standards Board issued Statement 140, which modified earlier rules on how companies could securitize loans[1] and laid the groundwork for a robust and highly profitable securitization industry,[2] just as math wizards appeared to be solving the challenges of calculating securitization risks and pricing the bonds.

In securitization, financial institutions pool consumer and business loans, including home loans, and sell asset-backed securities backed by the loans. Banks finance securitization mainly by taking out repo loans and by selling asset-backed commercial paper.

(3) Regulation 1.25: The  Commodity Futures Trading Commission said broker-dealers could buy an expanded range of instruments, including asset-backed securities, with the funds they held for their clients and use those new investments as collateral for their own repurchase transactions. This created a surge in demand for asset-backed securities among broker-dealers. 

2001

(4) Market crises: The Federal Reserve dramatically dropped short-term interest rates after the dot.com and telecom busts,[3] and it took historic steps to keep the stricken repurchase market alive after the terrorist attacks of 9/11.[4]  Financial institutions began to rely more heavily on short-term repo funding to finance their consumer and business lending.

That meant they needed even more securities to use as collateral for the repo loans.

(5) Recourse Rule: Bank regulators made it easier for financial institutions to make more securities, by sharply reducing the amount of equity, or capital, that commercial banks and thrifts had to have in order to hold top-rated, private-label mortgage securities. (Private labels are asset-backed securities that are issued by financial institutions and not guaranteed by federal agencies like Fannie Mae and Freddie Mac.[5])

This encouraged banks to make more asset-backed securities, especially mortgage-backed securities, as long as the securities had a AAA or AA rating. The securities could get those top ratings by being insured by credit default swaps or by being the safest slices of a loan pool,[6]even a CDO pool.

This meant that for the first time rating agencies, instead of regulators, controlled how much equity banks had to have to hold mortgage securities – a development that proved disastrous because credit agencies over-rated the securities, and that meant giant banks would not have enough equity capital to survive the coming runs on securitized banking.

2003

Mortgage rates slipped below 6 percent for the first time in more than 30 years,[7] and short-term rates hit 45-year lows.[8] Demand for home loans was red hot, and investment banks piled into the mortgage securitization business,[9] borrowing on the repo market at 1 percent to securitize home loans paying 5.8 percent.[10]

(6) Rule 15c3-3: The Securities and Exchange Commission said broker-dealers could use an expanded range of instruments, including asset-backed securities, as collateral when they borrowed securities, and the securities lenders could reuse those new investments as collateral for their own repurchase transactions. Here was another reason for broker-dealers to want asset-backed securities.

2004

(7) ABCPaper Rule: Bank regulators said commercial banks needed 90 percent less equity for consumer and business loans if they moved them off their books to a trust that made and sold asset-backed securities and asset-backed commercial paper.[11] This encouraged companies like Citigroup to make more loans, to pass along to their trusts, to create more asset-backed commercial paper and more asset-backed securities to use as collateral to get more repo loans.

(8) Net Capital Rule: The Securities and Exchange Commission let investment banks use their own internal models to calculate risk and equity requirements.[12]So the bankers decided they needed a lot less equity to hold asset-backed securities.[13]This freed them to create more securities.

With securitized banking in full swing, commercial and investment banks, and their giant holding companies, grew rapidly.[14] But in mid-2004 the Fed started raising interest rates[15]and Americans cut back on home loans. Fannie and Freddie ‘s business fell precipitiously.

In normal circumstances, this would have been the end of the boom. But financial institutions kept the market going by stepping up their private-label issuance and reaching out to less credit-worthy borrowers. [16]

(9) Regulation 1.25: In 2004 and 2005 the Commodity Futures Trading Commission said broker-dealers could repo their clients’ collateral with others and in house, without their client’s prior writen consent.

2005

(10) ISDA template:[17]The International Swaps and Derivatives Association published a standardized contract that made it easy for financial institutions to insure asset-backed securities with credit default swaps. (Credit default swaps pay off if the insured security goes into default.) With this insurance, even crummy home loans could be made into asset-backed securities that got a top rating, required little bank equity, and made good repo collateral.

Soon even credit default swaps themselves were being pooled and made into securities – no home loans needed. This kept securitized banking going even after rising interest rates meant there were fewer new home loans to securitize. (Meanwhile, of course, financial institutions and other speculators were also using the credit default swaps to bet against the securities.[18])

This new supply of securities meant financial institutions could take out more repo loans, so they needed more repo lenders.

(11) Bankruptcy Abuse Prevention and Consumer Protection Act: Congress passed the Bankruptcy Act which  added repos collateralized with mortgages and interests in mortgages, including mortgage-backed securities and CDOs,  to the list of repurchase agreements that were exempt from the claims of other creditors if the repo borrower should happen to go bankrupt.[19] The idea was to head off systemic risk by preventing problems at a bankrupt company from spreading to another firm. Lenders valued that protection and stepped up their repo lending collateralized by mortgages and mortgage-backed securities. [20]

Already more than double its volume in 2000,[21]repo kept climbing.  But then in mid-2006 home prices peaked and began a steady, ominous decline, [22]  and subprime borrowers began to default.

Financial institutions kept the housing securitization boom alive with record volumes through mid-2007.  But in June 2007 repo lenders, worried about their collateral, began a quiet run on the repurchase market,[23] and in July the run began on asset-backed commercial paper. In time, banks could not get financing for their securitization pipeline.

The rest, as they say, is history.

*****

Readers will note that RepoWatch does not include the Gramm-Leach-Bliley Act of 1999 [24] as one of the key steps leading to the financial crisis, even though Editor Mary Fricker and her co-author Stephen Pizzo opposed it and testified against it in Congress.

That’s because commercial and investment banks have repo-ed vigorously for decades, and they’ve securitized since 1989, when an appeals court ruled that securitization did not violate the Glass-Steagall Act.[25] In other words, the basic cause of the financial crisis, securitized banking, was legal under Glass-Steagall.

That said, the Gramm-Leach-Bliley Act – and, just as important, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,[27]which said interstate branching could begin in 1997 – spurred bank consolidation and helped create the too-big-to-fail banks that today both dominate and destabilize financial markets, including the repurchase market. Gramm-Leach-Bliley also let financial institutions get into the same businesses, which meant the same panic hit them all, and it introduced the go-go Wall Street culture into commercial banking, which infected the way the biggest banks did business and cost them their clients’ trust, the only thing that stands between a bank and a run.

In these ways, Gramm-Leach-Bliley was a critical element of the crisis.

As yet unknown, because banks don’t have to disclose, is whether banks used Gramm-Leach-Bliley’s holding company structure to hide a destabilizing surge of in-house repos. (Update June 7, 2012: A June 4 report from MF Global bankruptcy trustee James W. Giddens reveals its use of in-house repos.)

(The 1933 Glass-Steagall Act said a commercial bank can not be affiliated with a company that is “engaged principally” in underwriting and dealing in securities.[26] The 1999 Gramm-Leach-Bliley Act said a parent company could own both a commercial bank and an investment bank.)

RepoWatch also does not include the Commodity Futures Modernization Act of 2000[28] as one of the key steps leading to the financial crisis. That’s because most banks have been able to insure loans and securities with credit default swaps since a Federal Reserve decision in 1996.[29]

That said, derivative volume rose rapidly after 2000, often financed by repo,  and regulators have claimed they could have dealt with the crisis at less cost to the taxpayer if they had been regulating credit default swaps and had more information about them. In that way, the Commodity Futures Modernization Act was a critical element of the crisis.

(The 2000 Commodity Futures Act deregulated derivatives traded between private parties. Credit default swaps were the derivative most responsible for systemic risk during the financial crisis.)

-30-

For more information, read the following tab on the RepoWatch home page:

Finding a Fix, which describes proposed fixes for the repurchase market.

 

I collected the following footnotes for my own use, to help me keep track of some of  my online sources. I’m leaving them here in case they’re helpful to you, too.    -Mary Fricker


[1] http://www.securitization.net/knowledge/accounting/fasb_140.asp Statement 140 was itself clarified by Interpretation No. 46 in 2003.

[12] http://www.sec-oig.gov/Reports/AuditsInspections/2008/446-a.pdf   Note: Published reports that the Net Capital Rule allowed investment banks to vastly increase their leverage were false. See http://www.fcic.gov/hearings/pdfs/2010-0505-Donaldson.pdf and http://www.sec.gov/news/speech/2009/spch040909ers.htm.

[13] http://info.worldbank.org/etools/docs/library/156603/housing/pdf/Gwinner.ppt and http://www.appraisers.org/Files/Education/ARM/CollateralandRiskBasedCapitalStandardsJC.pdf and http://www.gtnews.com/article/6309.cfm and http://www.highbeam.com/doc/1G1-152570958.html and http://www.gtnews.com/article/6599.cfm and http://www.aciforex.org/docs/briefings/acib_oct05.pdf and http://www.bis.org/publ/bcbs128c.pdf and http://www.ftmandate.com/news/fullstory.php/aid/1220/ and http://ipe.com/articles/print.php?id=16446 and http://reports.celent.com/PressReleases/200706062/EuroRepoMkt.htm and Felix Salmon at http://www.cjr.org/the_audit/ 11-24-10

[14] “Regulating Wall Street” p. 4.

[18] “The Big Short,” Michael Lewis. See page 49 for the ISDA agreement.

[20] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1569627 and “Regulating Wall Street” page 229-231.

[23] “Regulating Wall Street” pg.336, “The Fall of the House of Credit” pg. 202.

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