Commentary: Repos must be reformed

The repurchase market must be reformed, say two New York University professors and leading analysts of the financial crisis of 2007-2008.

“Although one of the main concerns of the Dodd-Frank Wall Street Reform and Consumer Protection Act soon to be signed by President Obama to law is systemic risk, it is disconcerting that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined,” say Viral V. Acharya and T. Sabri Öncü in a Stern School of Business blog July 16.

Acharya is the lead author of “Regulating Wall Street,” and he is Stern’s lead economist on the financial crisis of 2007-2008. T. Sabri Öncü co-authored the July 16 blog and the repo chapter in “Regulating Wall Street.”

The writers note that the financial crisis was a run on the shadow banking system, where “non-bank financial institutions borrow short-term in rollover debt markets, leverage significantly, and lend and invest in longer-term and illiquid assets.”

From the article:

Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market. Indeed, the financial crisis of 2007-2009 was triggered by a shadow bank run on two Bear Stearns hedge funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the repo market.

Some history from Acharya and Öncü:

Although loans secured by some collateral have been traced back at least 3000 years to ancient China, repos as we know them were introduced to the U.S. financial market by the Federal Reserve in 1917 to extend credit to its member banks after a war time tax on interest payments on commercial paper had made it difficult for banks to raise funds in the commercial paper market. …

During the period of high inflation in the 1970s and early 1980s, rising short-term interest rates made repos a highly attractive short-term investment to holders of large amounts of idle cash. Increasing numbers of corporations; local and state governments; and, at the encouragement of securities dealers, even school districts and other small creditors started depositing their idle cash in “repo banks” to earn interest rather than depositing money in commercial banks which did not pay interest on demand deposits.

 Furthermore, the U.S. Treasury started borrowing heavily after 1974, eventually changing the status of the U.S. from a creditor to a debtor nation and increasing the volume of marketable Treasury debt by a large amount. This led to a parallel growth in government securities dealers’ positions and financing, and the repo market grew by leaps and bounds.

An important change came in 1984 when federal bankruptcy laws exempted repos from other creditors’ claims if a repo borrower went bankrupt, the authors said.

Another change came in the mid-1990s when repos that had traditionally used government, federal agency and corporate debt as collateral began using the products of securitization.

Since the mid-1990s, it (the repo market) has grown to include a broad range of debt instruments as collateral, including all types of private-label mortgage-back securities such as residential mortgage-backed securities and commercial mortgage-backed securities, all types of asset backed securities such as auto loans, credit cards and student loans, as well as tranches of structured products such as collateralized mortgage obligations, collateralized loan obligations, collateralized debt obligations and the like.

In 2005 the bankruptcy exemption was extended to repos using this new type of collateral.

Then on June 20, 2007, two Bear Stearns hedge funds collapsed.

The collapse of these two Bear Stearns hedge funds was indeed a run on a shadow bank in the repo market. These two funds, one of which at its peak was levered 10 times its equity, speculated mostly in collateralized debt obligations (CDOs) on subprime mortgages, borrowed funds in the repo market and pledged their CDOs as collateral.

When the housing market changed course in the first quarter of 2006, the subprime mortgage market began to deteriorate. With the deterioration of the subprime market in the first half of 2007, creditors began asking the two Bear Stearns funds to post more collateral to back the repos by mid-June 2007.

When the funds failed to meet these margin calls, creditors led by Merrill Lynch threatened to declare the funds in default of repo agreements and seize the investments. In fact, on June 19, 2007, Merrill did seize $850 million of the CDOs and tried to auction them.

When Merrill was able to sell only about $100 million worth of CDOs, the illiquid nature and the declining value of subprime assets became evident.

Because of the bankrupcy exemption for repos, the hedge funds could not protect their securities by filing bankruptcy.

This was the beginning of a run on the shadow banking system in the repo market, according to the authors. Bear Stearns failed in March 2008, and “the entire Wall Street system of independent broker-dealers collapsed in a matter of seven months.”

The authors conclude:

The Dodd-Frank Act is completely silent on how to reform the repo market. This is a mistake given the systemic nature of the repo market and its structural weaknesses discussed above.

Unlike the liquidity risk that unsecured financing may become unavailable to a firm, the liquidity risk that secured repo financing may become unavailable to a firm is inherently a systemic risk: the markets for the repo securities held predominantly by the financial sector may become illiquid. 

Unless this systemic liquidity risk of repo market is resolved, the risk of a run on the repo market will remain.

At any rate, leaving the repo market as it currently functions is not an alternative; if this market is not reformed and their participants not made to internalize the liquidity risk, runs on the repo will occur in future, potentially leading to systemic crises.