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Bernanke: Repo was thought to be risk free

Bernanke

Bernanke

Top regulators did not understand the dangers lurking in the repo market, Federal Reserve Chairman Ben Bernanke told U.S. and European regulators in May.

Speaking to a May 13 Federal Reserve Bank of Atlanta conference and a May 29 workshop in Basel, Switzerland, Bernanke outlined the run on financial markets in the days before and after Bear Stearns’ gunshot wedding with JP Morgan March 24, and he discussed the Fed’s reasons for the steps it took in the months before and since.

From the speeches:

In modern financial systems, the combination of effective banking supervision and deposit insurance has substantially reduced the threat of retail deposit runs. Nonetheless, recent events demonstrate that liquidity risks are always present for institutions–banks and nonbanks alike–that finance illiquid assets with short-term liabilities.

For example, since August, mortgage lenders, commercial and investment banks, and structured investment vehicles have experienced great difficulty in rolling over commercial paper backed by subprime and other mortgages.

More broadly, a loss of confidence in credit ratings led to a sharp contraction in the asset-backed commercial paper market as short-term investors withdrew their funds.

And remarkably, some financial institutions have even experienced pressures in rolling over maturing repurchase agreements (repos). I say “remarkably” because, until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations.

In March, rapidly unfolding events demonstrated that even repo markets could be severely disrupted when investors believe they might need to sell the underlying collateral in illiquid markets. Such forced asset sales can set up a particularly adverse dynamic, in which further substantial price declines fan investor concerns about counterparty credit risk, which then feed back in the form of intensifying funding pressures.  ….

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