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Treasury Secretary Paulson: The crisis was a bank run

Former Treasury Secretary Henry M. Paulson, Jr.’s book about the crisis, “On the Brink, Inside the race to stop the collapse of the global financial system,” has some compelling passages about the pivotal role the repurchase market played in the financial crisis of 2007-2008.

From the book:

Page 72 – By August 15 (2007), Countrywide Financial Corporation, the biggest U.S. mortgage originator, had run into trouble. It had funded its loans in an obscure market known as the repurchase, or repo, market, where it could essentially borrow on a secured basis. Suddenly its counterparties were shunning it. On the following day, it announced that it was drawing down on $11.5 billion in backup lines with banks, unnerving the market. A week later, Bank of America Corporation invested $2 billion in the company in return for convertible preferred shares potentially worth 16 percent of the company. (It would agree to buy Countrywide in January 2008.)

Page 98 – In recent years banks had borrowed more than ever – without increasing their capital enough. Much of the borrowing to support this increase in leverage was done in the market for repurchase agreements, or repos, where banks sold securities to counterparties for cash and agreed to buy them back later at the same price, plus interest.

While many commercial banks had big pools of federally insured retail deposits to rely on for part of their funding, the investment banks were more heavily dependent on this kind of financing. Dealers used repos to finance their positions in Treasuries, federal agency debt, and mortgage-backed securities, among other things. Financial institutions could arrange the repos directly with one another or through a third-party intermediary, which acted as administrator and custodian of the securities being loaned. Two banks, JPMorgan and Bank of New York Mellon, dominated this triparty repo business.

The market had become enormous – with perhaps $2.75 trillion outstanding in just the triparty repo market at its peak. Most of this money was lent overnight. That meant giant balance sheets filled with all kinds of complex, often illiquid assets were poised on the back of funding that could be pulled at a moment’s notice.

This hadn’t seemed like a problem to most bankers during the good times that we’d enjoyed until the previous year. Repos were considered safe. Technically purchase and sale transactions, they acted just like secured loans.

That is to say, repos were considered safe until the times turned tough and market participants lost faith in the collateral or in the creditworthiness of their counterparties – or both. Secured or not, no one wanted to deal with a firm they feared might disappear the next day. But deciding not to deal with a firm could turn that fear into a self-fulfilling prophecy.

A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds. Bear had hundreds, maybe thousands, of counterparties – firms that lent it money or with which it traded stocks, bonds, mortgages, and other securities. These firms – other banks and brokerage houses, insurance companies, mutual funds, hedge funds, the pension funds of states, cities, and big companies – all in turn had myriad counterparties of their own. If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. To meet demands for payment, first Bear and then other firms would be forced to sell whatever they could, in any market they could – driving prices down, causing more losses, and triggering more margin and collateral calls. The firms that had already started to pull their money from Bear were simply trying to get out first.

That was how bank runs started these days.

Page 185 – One New York Fed staffer noted that Lehman’s funding was increasingly problematic. JPMorgan had renewed a week-old $5 billion collateral call that day. It felt like Bear Stearns all over again, with a critical difference: There were much bigger concerns about the losses in Lehman’s balance sheet. Many were worried that all the bad news coming out would lead banks to begin to pull their funding. Lehman borrowed $230 billion overnight in the repo market – an extraordinary reliance on short-term funding that could be pulled at a moment’s notice. Lehman could easily become the victim of a run triggered by a widespread loss of confidence.

Page 231 – (Tuesday, Sept. 16, 2008) When investors – pension funds, mutual funds, insurance companies, even central banks – couldn’t withdraw their assets from Lehman accounts, it meant that in the interlinking daisy chain of the markets, they would be less able to meet the demands of their own counterparties. Suddenly everyone felt at risk and increasingly wary of dealing with any counterparty, no matter how sterling its reputation or how long a relationship one firm had had with another.

The vast and crucial Treasury repurchase market, under duress since August 2007, began to shut down.

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