The biggest threat to the financial system during the crisis was the run on the repurchase market, especially the tri-party operation, Federal Reserve Chairman Ben Bernanke told the Financial Crisis Inquiry Commission in Nov. 17, 2009, testimony just released by the commission. The most critical repair needed to prevent another financial crisis is to make sure no institution is too big to fail, he said.
In his testimony, Bernanke repeatedly returned to the repo theme, urging the commissioners to include the run on the repurchase market in their research into the causes of the crisis. Credit default swaps were a threat, but they were not a cause of the crisis, he said.
Here are some comments from his testimony:
Banks that are too big to fail are “a very, very serious problem, and one that was much bigger than was expected. And I think it’s absolutely critical that if we do only one thing in financial reform, it is to get rid of that problem,” he said.
He urged commissioners to review Yale professor Gary Gorton’s studies on the run on repo.
I think one of the things that struck me the most about this, though, was liquidity which, again, we saw in the crisis in September and October. We saw what are, again, old-fashioned bank runs, except they were much more sophisticated. For example, runs in the tri-party repo market, where what we used to think was very stable funding, which is funding through repurchase agreements where the investment banks would put out assets overnight and use that as collateral, they thought that was a pretty much foolproof form of short-term funding. But in a crisis where people began to doubt the liquidity or the value of those assets, the haircuts went up and you got into a vicious cycle which led to the Bear Stearns collapse and was important in the Lehman collapse as well.
The tri-party repurchase market was in danger, he said.
So let me first say that the toughest choice we made was the Bear Stearns action. It was the first one. And it came in the middle of a very sharply intensifying financing crisis in March of 2008. What we were seeing at that time was exactly this cycle of worsening haircuts, that is, where the financing — so that Bear Stearns was the weakest of the six or five investment banks. The investment banks relied on this repurchase agreement, overnight tri-party repo financing model. And this is when that model was really beginning to break down. And as the fear increased, the lenders, via the tri-party repo market and other short-term lending markets, again, began to demand larger and larger haircuts, premiums, which was making it more and more difficult for the financial firms to finance themselves and creating more and more liquidity pressure on them. And it was heading sort of to a black hole. Considered at the time of Bear Stearns – and I think we’ll want to give you a much fuller answer at some point — was that the collapse of Bear Sterns might bring down the entire repo market, the entire tri-party repo market, which is a two-and-a-half trillion-dollar market, which was the source of financing for all the investment banks and many other institutions as well. Because if it collapsed, what would happen would be that the short-term overnight lenders would find themselves in possession of the collateral, which they would then try to dump on the market. You would have a big crunch in asset prices. And probably what would have happened would — our fear, at least — was that the tri-party repo market would have frozen up. That would have led to huge financing problems for other investment banks and other firms; and we might have had a broader financial crisis.
Later he returned to the repo theme.
And again, to answer your question most directly, I think we were primarily focused on the potential collapse of the short-term funding markets, particularly the overnight repo markets and tri-party repo markets, which would have created a contagion to many other firms.
J.P. Morgan’s role in the tri-party repo market was critical, Bernanke said.
So, fortunately, J.P. Morgan was pretty stable. But J.P. Morgan actually is the bank that runs — one of the two banks — that runs the tri-party repo market. J.P. Morgan’s failure would have been a huge problem because that market would have essentially been inoperative because there are only two banks that run in that market, and they don’t have compatible computer systems.