FDIC remarks about repos are “really, really important”

FDIC chairman Sheila Bair recently said secured lenders should have to carry more of the cost of bank failures.

Joseph Mason, banking professor at Louisiana State University, saw that news reported by Bloomberg October 5, 2009, and he doesn’t think many people understand why Bair’s “remarks about repos are really, really important.”

That’s because most people don’t understand that much of the financial meltdown was on the repurchase market, and the 2005 Bankruptcy Act made repos exempt from bankruptcies, so when a bank fails, the FDIC can not collect from repo lenders who are creditors of the bank.

From a column Mason posted at U.S. Economonitor October 6, 2009:

While the Bloomberg piece was in introduction to the debate, in order to properly understand the weight of Ms. Bair’s remarks, you really have to understand the dynamics of the meltdown. Few people, however, still understand what happened in the grander scheme.

In the years leading up to the crisis there was a growing reliance upon market funding the entire mortgage origination pipeline, taking the entire operation off of many bank balance sheets, just as non-bank “mortgage bank” monoline (non-bank bank, not financial guarantors) financial institutions worked without that balance sheet to begin with.

The idea became to finance short-term day loans to lenders on a daily basis, which were repaid upon selling the loans into several-week repo commitments as longer-term warehousing and, later, monthly securitizations as more permanent funding. The short story of the crisis is that securitization was evaporating all through 2007 leading to increased margin calls on repo warehouse funding, and the eventual shutdown of day loans at various times (depending on which institution you are talking about) before Lehman, with Lehman marking the end of the road for everyone.

The key to the arrangements was increased acceptance of repo funding by commercial banks and other mortgage originators, as well as bankruptcy courts, in the past decade.

That acceptance of repo funding is rooted in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) which said repo lenders could use mortgage-backed securities as collateral and it couldn’t be seized by the bankruptcy court if the borrower went bankrupt.

So what the FDIC is struggling against is really a violation of absolute priority, memorialized by the BAPCPA, that puts traditional bank assets squarely out of the reach of the deposit insurer. The FDIC is now standing behind these margin claims, liquidating banks that have no assets left in them after repo counterparties bleed them dry of collateral and dealing with counterparty fallout among commercial banks with claims behind the repo collateral.