Currently, repo loans and their collateral may not be seized by creditors during a borrower’s bankruptcy. Critics say the exemption from bankruptcy lets repo lenders ignore risk and became especially dangerous after the 2005 Bankruptcy Act added repos collateralized with mortgage-backed securities to the list of exempted repos.
Critics think repo lenders should have to take a loss, also called a haircut, when a borrower fails, to make them more careful lenders. Bankers disagree, according to Tett:
Some senior bankers fear that if haircuts are suddenly introduced, it could potentially spark a surge in the cost of repo funding, or even cause that source of funding to shrivel dramatically. Or as the head of one large bank says: “The implications will be horrendous…doing this would be madness.”
The financial panic in 2007 and 2008 was driven by repo lenders who feared losses and demanded their money back, even though the loans were secured and they held the collateral. Tett writes:
If that amount of panic could erupt even without creditors facing possible haircuts – meaning that loans were fully secured against assets – who knows what might occur with a haircut in place. And it is not just the banks which are alarmed about that idea: some officials at the US Federal Reserve are also quietly agitating to squash the haircut idea.
Some analysts claim the addition of mortgage-backed securities to the repo collateral that creditors could not seize made such repos more attractive to lenders, spurred demand for mortgage-backed securities, and played a key role both in the deteriorating quality of repo collateral and in the growth of the repurchase market in the years leading up to the financial crisis of 2007 and 2008.