In testimony before the Financial Crisis Inquiry Commission May 6, former Treasury Secretary Henry M. Paulson, Jr. discussed four areas of the financial system “where flaws were exposed by the recent crisis”: securitization, repurchase agreements, commercial paper, and money market funds.
He said he believes these markets can work “function productively
with appropriate regulation and oversight.” About repos, he said:
The repurchase agreement market is a major source of funding for financial institutions. A repurchase agreement—or “repo”—is essentially a form of short term secured lending. One institution sells a security—such as a Treasury bond, agency debt, or mortgage-backed security—to a counterparty for cash, and agrees to buy it back later, typically the following day, at the same price, plus interest. Institutions may engage in repos directly with one another or through a third-party intermediary who administers the transaction and serves as custodian of the securities being transacted—a so-called “tri-party repo” transaction.
By the time the crisis hit, the repo market had grown to an enormous size at an astonishing speed. Architecture, infrastructure, and regulation had not kept up. Lending practices had become sloppy, lenders vastly expanded the collateral they would lend against, without demanding sufficient protection, and no single regulator had the necessary information and the authority for dealing with the attendant problems.
Partly as a result, many firms placed too much faith in the market’s seemingly constant supply of easy liquidity. When the crisis hit, these problems came home to roost as the markets declined. Lenders became increasingly strict about the types of collateral they would accept, and borrowers consequently found their access to liquidity evaporating. Bear Stearns, for example, which relied heavily on tri-party repo to meet short term funding needs, saw its cash on hand drop from $18 billion to $2 billion in the few days before its rescue, due in part to its loss of access to the repo markets.
The crisis of 2008 was characterized by a run on the secured borrowing of a number of financial institutions.
I believe the repo market can, and should, be able to function efficiently while serving us better during future periods of market stress. It makes sense for firms to be able to use their securities as collateral to fulfill certain short term funding needs, rather than being required to always obtain wholesale credit from large banks. For this to work, however, the market must be well supported by a robust infrastructure, appropriate technology, and intelligent oversight. For example, the Federal Reserve has sponsored an industry-led task for to develop enhancements to the policies, procedures, and systems that support the tri-party repo market, and I look forward to the results of those efforts, some of which should also be applicable to the broader repo market. In addition, the crisis has underscored the point that, even in a well functioning market, firms cannot rely on shortterm funding in place of proper liquidity management.