The Financial Crisis Inquiry Commissions’ long-awaited report describes the run on repo with some vivid detail, but it barely mentions repo in its conclusion, which is all that most people will read. Instead, it focuses on mortgages, credit default swaps and credit rating agencies.
The commission did not respond to a RepoWatch e-mail asking why the conclusion pays so little attention to the repurchase market.
The report does not contain suggestions for avoiding the next crisis, because the commission was asked only to examine the causes of the 2007 and 2008 crisis.
The Official Government Edition of the report has no index in its print version, but there is an Index online.
From pages 293 and 294:
Systemic Risk Concerns, The Federal Reserve: “When People Got Scared”
The most pressing danger was the potential failure of the repo market—a market that “grew very, very quickly with no single regulator having a purview of it,” former Treasury Secretary Henry Paulson would tell the FCIC. Market participants believed that the tri-party repo market was a relatively safe and durable source of collateralized short-term financing. It was on precisely this understanding that Bear had shifted approximately $30 billion of its unsecured funding into repos in 2007. But now it was clear that repo funding could be just as vulnerable to runs as were other forms of short-term financing.
The repo runs of 2007, which had devastated hedge funds such as the two Bear Stearns Asset Management funds and mortgage originators such as Countrywide, had seized the attention of the financial community, and the run on Bear Stearns was similarly eye-opening. Market participants and regulators now better appreciated how the quality of repo collateral had shifted over time from Treasury notes and securities issued by Fannie Mae and Freddie Mac to highly rated non-GSE mortgage–backed securities and collateralized debt obligations (CDOs). At its peak before the crisis, this riskier collateral accounted for as much as 30% of the total posted. In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 had dramatically expanded protections for repo lenders holding collateral, such as mortgage-related securities, that was riskier than government or highly rated corporate debt. These protections gave lenders confidence that they had clear, immediate rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Dimon, the CEO of JP Morgan, told the FCIC, “When people got scared, they wouldn’t finance the nonstandard stuff at all.”
To the surprise of both borrowers and regulators, high-quality collateral was not enough to ensure access to the repo market. Repo lenders cared just as much about the financial health of the borrower as about the quality of the collateral. In fact, even for the same collateral, repo lenders demanded different haircuts from different borrowers. Despite the bankruptcy provisions in the 2005 act, lenders were reluctant to risk the hassle of seizing collateral, even good collateral, from a bankrupt borrower. Steven Meier of State Street testified to the FCIC: “I would say the counterparties are a first line of defense, and we don’t want to go through that uncomfortable process of having to liquidate collateral.” William Dudley of the New York Fed told the FCIC,“At the first sign of trouble, these investors in tri-party repo tend to run rather than take the collateral that they’ve lent against. . . . So high-quality collateral itself is not sufficient when and if an institution gets in trouble.”
Moreover, if a borrower in the repo market defaults, money market funds—frequent lenders in this market—may have to seize collateral that they cannot legally own. For example, a money market fund cannot hold long-term securities, such as agency mortgage–backed securities. Typically, if a fund takes possession of such collateral, it liquidates the securities immediately, even—as was the case during the crisis—into a declining market. As a result, funds simply avoided lending against mortgage-related securities. In the crisis, investors didn’t consider secured funding to be much better than unsecured, according to Darryll Hendricks, a managing director and global head of risk methodology at UBS, as well as the head of a private-sector task force on the repo market organized by the New York Fed.