From the editor,
I have written the following short article to explain in simple terms, for the average American, why repo matters.
If you find that parts are hard to understand, I hope you will let me know, so I can try to make them better.
Something about the financial crisis doesn’t add up
If you’re like many Americans, the financial crisis has left you feeling furious and helpless. This huge human tragedy – and no one’s to blame?
How did this happen?? You probably feel powerless to avoid the next collapse.
But that’s because there’s something about this crisis that you don’t know.
My guess is you’ve heard that some time ago many bankers, encouraged by politicians, regulators and deregulation, lowered their lending standards and made vast numbers of home loans to people who would not normally have qualified for a loan. Then the bankers sold those home loans to investors worldwide, to get the money to make more home loans. This chain is a highly profitable business called securitization.
Bankers kept making home loans and selling them as long as they could. But then waves of the new homeowners couldn’t make their monthly mortgage payments, and every link in the securitization chain suffered big losses, from homeowners through bankers to investors. In 2008 U.S. officials decided some of the Wall Street banks and their trading partners were so big that taxpayers had to bail them out, to prevent an even worse recession than we have.
All of this is true. But parts of it don’t add up. For example, investors regularly lose tons of money. In the dot.com and telecom busts, investors lost almost twice what they lost on mortgages. Why were mortgages so crippling?
Why were the bankers in trouble? Congressional hearings have been telling us about Wall Street trades that paid some bankers big bucks when mortgages went bad. Shouldn’t those banks have been winners, not losers?
Most important, why did all the financial markets seize up – including business loans, car loans, and money market funds – when the problem was in one corner of the mortgage market? Regulators said the crisis was “systemic.” What did that mean?
If this is confusing, it’s because the most important piece of the crisis story is missing. Here it is:
It turns out that one-fourth of the mortgages supposedly sold to investors were actually held by the bankers, who often used them as collateral to get overnight loans from each other and from other financial institutions.
This kind of lending has a name. It’s called repurchase (or “repo”) lending, because technically the borrower sells the collateral to the lender and promises to buy it back, to “repurchase” it, the next day – although usually the lender agrees to renew the loan for another day.
This was how bankers got much of the money to make home loans. Bankers got a repurchase loan, used the repo money to make or buy home loans, used the home loans as collateral to get more repurchase loans, used this new repo money to make or buy more home loans … and so on. It was a very profitable cycle, but it was built on bankers’ going deeper and deeper in debt to their repo lenders.
Bankers also used this cycle to finance business loans, car loans, credit cards, student loans and much more. In the past decade, securitization and repos – which together are called securitized banking – came to provide half the credit in this country. This securitized lending eventually equaled traditional lending, which is done by banks using their depositors’ money. Big banks prefer securitized lending because it’s less regulated and more profitable.
Large banks also use repos to finance their Wall Street trading and other operations.
Every night about $7 trillion is borrowed on the U.S. and European repurchase markets, yet most Americans have never heard of it because the transactions occur privately among global financial institutions. In the U.S., 20 companies do half the business.
Participants include the mega-banks, money market funds, hedge funds, mortgage giants Fannie Mae and Freddie Mac, the Federal Reserve, mutual funds, states, municipalities, large businesses, pension plans, mortgage lenders, insurance companies, some community banks and other financial institutions.
These companies become intricately interconnected as both borrowers and lenders on the repurchase market.
The financial crisis was “systemic” mainly because of repo.
In 2007 and 2008, repo lenders started to worry about the quality of their collateral and the financial condition of the repo borrowers. They refused to renew their repo loans. Suddenly forced to repay, banks like Lehman Brothers hemorrhaged cash and plummeted toward insolvency.
When frightened repo lenders demanded their money back, it was just like 100 years ago when frightened depositors lined up outside their banks and demanded their deposits back.
In 1907 it was called a run on the bank. In 2007 it was called a run on repo.
All financial markets panicked. In the chaos, securitization fell 44 percent in one year. With the fall vanished $1 trillion a year in loans for cars, commercial real estate, credit cards, large and small businesses, many other consumer and business needs and, of course, for mortgages.
The repurchase market, then, was the key transmission mechanism, the systemic risk, the amplifier, that carried the shock wave from a small part of the housing market through the canyons of Wall Street to all corners of the economy.
Unfortunately, the repurchase market is not being fixed, and the banks that use that market are bigger than ever. Congress has focused its fixes on mortgages and on mortgage derivatives, which are a Wall Street contract that banks also use as repo collateral. But that won’t stop the next run on repo if lenders panic over a different kind of collateral or hear a false rumor and panic for no reason at all.
In the 1930s, after decades of bank runs, and against the wishes of key bankers and the Roosevelt Administration, Americans finally forced Congress to create FDIC insurance for commercial banks, paid for by the banks. Ever since, Americans have banked with confidence that their deposits were safe.
Hopefully we can deal as effectively with the repurchase market, without having to endure decades of repo runs first.
The first step is to tell your friends and your elected representatives about the repurchase market. Many have never heard of it, which is just fine with the companies that repo. Let your legislators know that some economists are proposing ways to fix the repo market. Ask them to get moving on this.
To help you get started, I have created www.repowatch.org, where you can learn more than you ever wanted to know about the repurchase market.
I know that fixing a system is not as satisfying as sending people to jail. We must do both. But fixing repo will make us safer.