Matt King had it right in 2008, joins Gorton, Milne


The Financial crisis of 2008 was not caused by financial institutions having to write down the value of subprime loans, collateralized debt obligations of asset-backed securities, asset-backed commercial paper, auction rate securities, and just plain old home loans.

Instead, it was caused by financial institutions borrowing too much on the repurchase and securities lending* markets, according to a research report by Citigroup analyst Matt King in London.

“Ho-hum,” RepoWatch readers must be saying about now. “This is very old news to us.”

But check out the date of the report: September 5, 2008, two days before the start of one of the most amazing two weeks in Wall Street history:

-Sept. 7: The Treasury Department seized mortgage giants Freddie Mac and Fannie Mae
-Sept. 15: Lehman Brothers declared bankruptcy
-Sept. 15: Bank of America took over Merrill Lynch at the urging of regulators
-Sept. 16: The Federal Reserve took control of American International Group
-Sept. 16: The Reserve Primary Money Fund broke the buck
-Sept. 21: Goldman Sachs and Morgan Stanley became commercial banks  in a flight to safety, ending the storied era of powerful Wall Street investment banks

King wrote his report after watching mortgage troubles mount since June 2006, repo slowly freeze since June 2007, sales of asset-backed commercial paper dry up since July 2007, Northern Rock fail in February 2008 and Bear Stearns collapse in March 2008.

Much of the focus on financials during the credit crunch has been upon writedowns. First on subprime and CDOs of ABS, then on ABCP, ARS and a string of other products, and now on more normal loan portfolios. Investors have been almost obsessive about finding the next ‘shoe to drop’.

Yet from a credit perspective, the major question facing all financials going forward is not one of writedowns but one of funding and leverage. After all, it was the catastrophic loss of funding caused by a sudden evaporation of confidence which led to the demise of both Bear Stearns and Northern Rock, not anything to do with writedowns.

The common strand linking those two institutions was their dependence on wholesale markets for funding. And yet their models were not so different from those of many other financial institutions today. The other US broker-dealers, in particular, are funded heavily through short-term repo and secured lending markets, and do not have the diversification implied by a large deposit base. Does this mean that they too are similarly vulnerable?

Yes, it did.

Read King’s whole 21-page report, “Are The Brokers Broken?” It’s the most concise yet thorough explanation RepoWatch has found of the panic that hit the financial markets in 2007-2008.

The paper puts King in a rare category of people who really did understand what was happening to the credit markets, as it was happening, and tried to tell others.

Also in that category are Yale professor Gary Gorton, who warned the world’s top economists in August 2008, and Loughborough University professor Alistair Milne, who spent July 2008 to March 2009 writing a book that would explain the panic to the average reader.

Other early warners, although without any of the critical context, were then-president of the Federal Reserve Bank of New York Timothy Geithner and Federal Reserve Chairman Ben Bernanke – informed by their vantage points as regulators, especially of tri-party repo – who used speeches in June and August 2008 to put the blame solidly on the repurchase market.

King’s report is notable not only for its date but also for its detail and for how his analysis has stood up over time.

In his report, King explained a repo feature that was little understood at the time: The very elements that made repo safe for lenders – short terms and collateral – made it dangerous for borrowers and the financial markets.

As we have argued elsewhere, and as is demonstrated by the failure of so many hedge funds, the very same features which are designed to make repo safe for cash lenders do tend to create risks for those who depend on it for their borrowing.

Moreover, and despite increasing scrutiny from regulators, we get the impression that repo remains extremely poorly understood by most investors, in part because accounting is confusing. In particular, we argue that brokers’ and banks’ gross usage of repo, revealed in footnotes of 10-Qs, far exceeds that which shows up on balance sheet.

King showed his readers in detail how to find the hidden repo in the financial statements of the major broker-dealers, and he estimated they were funding half their assets with repos.

They were.

That was risky, King explained.

These numbers imply a gross dependence on repo financing far larger than the on balance sheet numbers suggest. Suppose, for example, that counterparties were to become concerned about the stability of a broker, and became reluctant to execute trades with and place collateral with them. The broker would, of course, immediately pass on this difficulty in their refusal to provide financing to their clients. But that in turn might spark other changes in the clients’ behaviour, such as an abrupt decision to withdraw their unencumbered cash balances and place them elsewhere, and/or to move their broader business to another counterparty. The broker would probably find their ability to conduct day-to-day business providing liquidity in markets somewhat hampered, and in extremis might even start to find themselves running short of cash. If this sounds extreme, it is worth remembering that it was just such a run on cash – as a result of hedge funds moving their money elsewhere – which is thought to have precipitated the problems at Bear Stearns.

To summarize: If repo lenders or securities lenders stopped doing business with a broker, the broker’s hedge fund clients might also take back their money, and the broker could find itself short of cash.


King “followed the money,” as reporters are supposed to do but did not, and asked himself who were the repo lenders. He discovered they were giant securities lenders who then repoed out the cash they got from the securities borrowers, creating the rehypothecated daisy chains that are such a hot topic today.

Until now, we have not really considered the question who is providing all this financing, is prepared to lend such enormous volumes of collateral and indeed who would have them on hand to lend in the first place. It turns out that the vast majority comes from just a handful of  counterparties, whose obscurity is matched only by
their absolutely colossal size. To understand some of the shifts going on at present, we need to digress slightly to consider their role.

Securities lenders, to give them their full (and rather apt) title, are massive participants in both repo and reverse repo*, and their role is crucial to understanding not only broker-dealers’ current difficulties, but also much of the liquidity of markets in general. These are generally institutions like Bank of New York Mellon, or State Street, or JP Morgan, with custodial responsibility for the assets in end-investors’ portfolios. Although they do not own the assets themselves (indeed, they are held off balance sheet), they are given the authority by the end-investors (pension funds, central banks, and so on) to repo out their assets (which are mostly government bonds and agencies) in return for cash. They can then reinvest that cash so as to provide some extra return for the end-investors’ portfolios.

The reinvestments have an emphasis on security. Much consists of commercial paper (CP), or is deposited with externally managed money market funds. The bulk, though, consists of reverse repos, in which less liquid securities (such as corporate bonds, ABS, or equities) are accepted as collateral and the cash lent out in return for interest. Because these assets are generally of lower credit quality (and certainly lower liquidity) than are the original, mostly government or agency, assets, the interest rate received on this reverse repo is significantly higher than the rate paid on the original outbound repo.

King showed how profitable this all was, and he put numbers to it.

He showed that the danger lay in the collateral, in the margin calls.

He predicted that regulators were seriously worried.

At this point, it should be apparent that there are numerous reasons why the regulators are worried. The scale of the flows, their concentration, the size of the shifts, the sheer extent to which most people are unfamiliar with all this – all these argue for increased unease in a post-Bear Stearns world.

And finally, here’s his prescient conclusion, written in September 2008. It sounds a lot like our world today, doesn’t it?

At this point, it is hard to see exactly how all this plays out. Even if the transition is achieved smoothly, markets in future seem likely to be significantly less liquid than they were until recently, with both hedge funds and brokers unable to play the same role in a world of reduced leverage. Returns on equity will almost inevitably be lower, though higher bid-offer and greater power in asset pricing may help compensate somewhat. In general, it feels like the world of tomorrow will look more like the world of yesteryear – before leverage and liquidity embarked on their dizzy climb in the late 1990s. The brokers may not be broken, but in future we expect the financial system in general – and the brokers in particular – to become shadows of their recent selves.


*Securities lending, a smaller cousin to the repo market, is where asset managers lend securities, including stocks, in return for cash or other securities. Companies borrow securities mainly for short selling, to use as collateral for loans, and for hedging derivatives.

*Reverse repos are repos viewed from the side of the lender. In a reverse repo, the party lends cash and takes collateral in return.


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