When a repo borrower files bankruptcy, the repo lender has no worries. His collateral is exempt from the bankruptcy, thanks to a 1984 law that said bankrupt borrowers must immediately repay their repo loans in full. The purpose of the law was to prevent troubles at a bankrupt company from infecting the financial system. In other words, the purpose was to prevent systemic risk.
Things got even better for repo lenders in 2005, when Congress passed The 2005 Bankruptcy Act that added repos collateralized with mortgage-backed securities, including CDOs, to the list of repurchase agreements that were exempt from a bankruptcy and creditors could not seize.
Critics claim the bankruptcy exemption contributed to the financial crisis of 2007 and 2008, because it let repo lenders ignore risk and protected them from their bad decisions.
One of these critics is economist Carolyn Sissoko, author of “The legal foundations of financial collapse” published October 6, 2009.
To the above criticisms, she adds that repo lenders used to be cautious about demanding more collateral from a troubled borrower, for fear of driving the borrower into bankruptcy. But with the bankruptcy exemption, repo lenders feel free to demand more collateral at the first whiff of trouble, because whatever happens, the repo lender is protected. It appears the bankruptcy exemption created more systemic risk, not less.
Sissoko takes her criticism of the bankruptcy exemption a step further, asking: Is collateralized interbank lending an inherently destabilizing force in a financial system?
From her paper:
The collateralized interbank lending regime encourages banks to believe that their collateral is “liquid”, protecting them from losses in the event that a counterparty defaults. Adherence to this fallacy has two consequences: (i) banks do not set aside reserves or hold capital to protect themselves against losses that they cannot imagine, and (ii) banks do not monitor counterparties carefully, because they believe that they are fully protected by collateral. Both of these consequences are extremely detrimental to financial stability. …
At the least, the bankruptcy exemption for repos should be stopped, she says.
The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets. As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.
Further Sissoko thoughts about the 2005 Act:
It’s unfortunate that no statistics are collected on the size of the private sector repo market, because it seems likely that the market grew at an astounding pace after the 2005 Bankruptcy Act was passed, granting safe harbor protections to repos on over-the-counter securities and synthetic assets. ….
Pause for a moment to think about the implications of these changes. Repurchase agreements are a standard component of any broad measure of the money supply. It is now possible for a bank to write a swap that functions like an insurance contract on the returns of a mortgage security, to package that swap into a synthetic security and then to use the synthetic security as collateral to borrow money in a repurchase agreement.
Thus, the 2005 law encourages the monetization of synthetic and cash securities in repo markets, because if the bank goes bankrupt, then the repo counterparty’s claim has far greater privileges in bankruptcy than that of a bondholder – with careful management of collateral the repo counterparty can be all but certain of being paid in full. …
Sissoko discusses the financial collapse of 2008:
This repo market instability became evident in March 2008, when rumors were swirling about Bear Stearns’ financial condition. Counterparties did not want to risk holding collateral that could only be sold at fire sale prices in the event of a Bear Stearns’ bankruptcy – so they refused to lend to Bear against anything but the highest quality collateral.
Since Bear Stearns financed half of its balance sheet on the repo market, this withdrawal of credit was disastrous. In the absence of credit drawn on repos Bear did not have the liquidity necessary to meet its short-term obligations.
In the case of Bear Stearns, fear of a bankruptcy filing precipitated a withdrawal of credit that made bankruptcy almost inevitable – and destroyed the firm. In September 2008 Lehman Brothers collapsed when it too faced a bank run as fellow bankers withdrew credit and issued collateral calls. At the time of the Lehman failure, Merrill Lynch was at risk of the same treatment and was saved only by Bank of America’s eleventh hour purchase. Within days Goldman Sachs and Morgan Stanley were also at risk – exactly one week after Lehman filed for bankruptcy the Federal Reserve announced expedited approval for the transformation of these firms into bank holding companies with full access to the Fed’s support for commercial banks.
In short, every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued.
Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs. Whenever there is some small likelihood that a firm a might declare bankruptcy, counterparties protect themselves from the possibility of losses in a fire sale by withdrawing credit from the firm – and driving it into bankruptcy.
The repo markets we have now can only be described as fundamentally unstable.