About Repo

  April 7, 2011 (latest update August 8, 2021)

From the editor:

When Treasury Secretary Henry Paulson said in September 2008 that he needed $700 billion to fix the financial markets, I knew subprime mortgages alone could not have done that kind of damage. Didn’t banks pool those loans and sell slices of the pools to investors? Don’t investors make and lose billions of dollars on the financial markets every day? Why were their losses suddenly landing in the taxpayers’ laps? Something else had to be involved, something hidden, something I wasn’t aware of, something dangerous.

The answer turned out to be:  The repurchase “repo” market.

What follows are (1) a definition, (2) a short article for beginners and (3) a 2011 story with much more detail, written when this blog was born.

Thanks for your interest.

                                                                     Mary Fricker
Editor, RepoWatch

(1) A definition:

The repurchase (“repo”) market is where giant financial institutions borrow trillions of dollars from each other and from central banks every day, often just for overnight, using securities as collateral. If repo lenders lose faith in the collateral or in the borrowers – as they did in 2007-2008, when they lost faith in the repo borrowers who used mortgage securities as collateral – they will demand more collateral or repayment, which can quickly drive the repo borrowers into bankruptcy. That was the prime cause of the financial panic in 2007 and 2008.

That’s why Federal Reserve Chairman Ben Bernanke told the Financial Crisis Inquiry Commission:

As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period. . . only one . . . was not at serious risk of failure. So out of maybe the 13 — 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.

(2) A short article for beginners:

Something about the financial crisis doesn’t add up

 If you’re like many Americans, the 2008 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.

That’s because there’s something about this crisis that you may not know. Something we can fix. But if we don’t fix it, get ready for more financial panics in your future.

My guess is you know that some time ago many bankers, encouraged by politicians, regulators, shareholders, deregulation and easy profits, lowered their lending standards and made 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 lending chain is called securitization.

As you probably have heard, 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 our current recession from becoming a depression.

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?

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. Those bankers often used the mortgages as collateral to get overnight loans from each other and from other financial institutions.

This kind of borrowing has a name. It’s called repurchase (or “repo”) borrowing, 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.  The cycle was very profitable for bankers, but it depended on their 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 trillions of dollars are borrowed on the U.S. and European repurchase markets, yet most Americans have never heard of this because the transactions occur privately among global financial institutions.

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, university endowment funds, some community banks and other financial institutions.

These companies become intricately interconnected as both borrowers and lenders on the repurchase market.

Repo was the key reason that the financial crisis was “systemic.”

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 post more collateral or repay, financial institutions like Countrywide, Bear Stears and 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, triggered a shock wave, and it was a key transmission mechanism, an 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 and to the American taxpayer.  

The 2008 financial crisis was not caused by homeowners who borrowed too much money. It was caused by big financial institutions that borrowed too much money, much of it on the repurchase market.

Unfortunately, the repurchase market is not being fixed, and the main users of that market are bigger than ever.  Congress has focused its fixes on banks, mortgages and derivatives. 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 separate commercial banks (they take deposits and make loans) from investment banks (they underwrite and trade securities), prohibited non-banks from taking short-term deposits, and created FDIC insurance for commercial banks, paid for by the banks. For 50 years, Americans 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.

(3) A story with much more detail, written in 2011 when this blog was born:

Today, more than two years after Treasury Secretary Henry Paulson stunned Americans with a frantic plea to Congress for $700 billion[1] to save the world’s financial system from collapse, the tragedy is clear.

Millions of Americans are losing their homes, their businesses and their jobs in the worst financial crisis since the Great Depression. Taxpayers are spending billions of dollars to keep banks from failing, so they won’t thrust the nation into a second Great Depression.

How did this happen?

Many experts say the crisis was caused by people who borrowed money to buy homes they could not afford.  Where did lenders get the money to pump up the housing bubble and make such a mess?

Much of it came from the repurchase market.[2]

When Federal Reserve Chairman Ben Bernanke[3] and Timothy Geithner,[4] then president of the Federal Reserve Bank of New York, said mortgages caused the financial crisis but systemic risk and a crisis in the credit markets forced the taxpayer bailout, where did that risk and crisis come from?[5]

Much of it came from the repurchase market.[6]

Two years later, what’s been done to corral the repurchase market?

Very little.[7] 

Yet reforming the repurchase, or “repo,” market is critical for restoring sound economic growth. That’s because repo is a vital engine of finance, it’s coming back,[8] and the U.S. can’t afford another repurchase market like the last one. [9]

“Without some repo reform, we are at risk for another panic,” said Yale professor Gary Gorton, whose book “Slapped by the Invisible Hand” dissects the role the repurchase market played in the financial crisis of 2007 and 2008.*  Bernanke has said chapters three and four top his list of recommended reading for people who want to understand the systemic danger of the crisis.[10]

The repurchase market is the lifeblood of the world’s financial system. It is where financial institutions and large businesses do much of their borrowing and lending, mainly with each other. It’s how many of them pay for their securities holdings. Sometimes it’s called the plumbing for the financial markets.

It’s  how lenders financed much of the housing boom.

Transactions are called repurchases, or “repos,” because a typical deal involves a borrower that gets cash from a lender, puts up securities as collateral,[11] and agrees to “buy” the securities back soon, plus interest, often the next day.[12] In other words, repos are like short-term collateralized loans. (**See note below for ways repos differ from collateralied loans.)

Every day money market funds[13] and other large financial institutions lend much of Americans’ personal and business savings[14] to each other on the repurchase market. Until it collapsed in the crisis of 2007 and 2008, it was one of the biggest financial markets in the world.[15]

Repo is a key way that money flows in a Wall Street banking system that many economists call shadow banking. It’s called shadow banking because it’s where companies borrow and lend outside the traditional FDIC-insured bank system of deposits and loans and because it’s less known and less regulated than traditional banking.[16] In the past decade, banks moved half their business into the shadows, where they could grow faster and make more money.

At repo’s peak in early 2008,[17] daily outstanding repo loans in the U.S. totaled $6 trillion[18] to $10 trillion,[19] based on industry and banking estimates,[20] and the repo market in Europe was similar.[21] That means repo lending in the U.S. before the crisis was roughly equivalent to traditional bank lending.[22] The exact size of the U.S. repo market is not known because no one collects all the data.[23]  Worldwide, a number of countries have repo markets or are developing them.

Although thousands[24] of financial institutions repo in the U.S., the market is dominated by mega-bank holding companies, billion-dollar mutual fund families, mortgage giants Fannie Mae and Freddie Mac,[25] and other global finance firms, the largest of whom each routinely have $100 billion in repo outstanding daily,[26] according to an industry report. At the peak of the market in early 2008, the largest positions exceeded $400 billion.[27] Though that has fallen, it still exceeds $200 billion.[28]

These giants drove the housing bubble,[29]and in 2007 and 2008 some panicked, amid doubts that repo borrowers and the mortgage-backed securities they sometimes used as collateral were sound, and they stopped making repo loans and related investments. Their “run” on repo borrowers to get their money back became a run on repo and shadow banks that was like the historic runs by depositors on traditional banks a century ago, before bank deposits had FDIC insurance.[30] It nearly froze credit and commerce in their tracks.

This system-wide rout was a key reason problems in a niche sector[31] of the housing market became a systemic[32] financial crisis that threatened the broad economy,[33] according to a number of economists and regulators.[34] This was how regulators discovered that some of the nation’s financial institutions were too big and too interconnected to fail, and this was when Paulson dropped his $700 billion bombshell.

Many analysts believe a cycle of financial crises will continue[35] until a safety net like FDIC insurance is extended to repo and shadow banking or until the repurchase market is fundamentally altered or abolished.[36]

Yet, remarkably, Congress has largely ignored repos[37] and most Americans have never heard of them, even though they are critical to the credit markets and to every American who ever needs a loan.

“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 the future, potentially leading to systemic crises,” said New York University professor Viral Acharya in a July 2011 report. Acharya has led the Stern School of Business’s coverage of the financial crisis,[38] and he is the lead author of their book, “Regulating Wall Street.”

(Editor’s Note: American Public Media and the Financial Times have user-friendly videos that explain repos. RepoWatch editor Mary Fricker tried to explain repos simply for KRCB-FM, a National Public Radio station in Rohnert Park, California, both here and here.)

Repurchase agreements have been around for decades, [39] and their potential to create systemic risk has long been known. In 1983 a U.S. Senate report said:

 The repo market is as complex as it is crucial. It is built upon transactions that are highly interrelated. A collapse of one institution involved in repo transactions could start a chain reaction, putting at risk hundreds of billions of dollars and threatening the solvency of many additional institutions.

Twenty-five years later, Lehman Brothers’ failure proved their point.

Today the wounded repo market is starting to recover.[40] In time it could become more important than ever, as the Dodd–Frank Wall Street Reform and Consumer Protection Act cracks down on traditional banking[41] but puts few restrictions on repo.

That’s a problem, critics claim, because while it may be well and good for the Dodd-Frank Act to demand more oversight of mortgages and derivatives, 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.

As the financial crisis showed, the repo business can be very profitable and bankers will use whatever collateral they can get away with.

“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,” said Acharya.

To be clear, the repurchase market is not about financial institutions having to buy back bad loans, which is another repurchase activity getting a lot of press in the current crisis.

The repurchase market grows

In recent years, repo has become critical to modern finance. Here’s how:

Money market funds and other large financial institutions amassed trillions of dollars that they needed to put someplace safe for short periods of time and earn interest. They could deposit the money in a bank checking account, but each deposit was only insured by the FDIC up to $100,000, and the rest could be lost if the bank failed. What to do? 

Another option was to lend the money on the repurchase market, to a company that had securities and needed cash. Because repos are brief, often overnight, lenders could get their money back almost at will. Instead of FDIC insurance, they got securities they could sell if the repurchase failed. To these lenders, making a repo loan felt safe, much like making a deposit in an FDIC-insured bank.

Now, imagine you’re an investment bank or any other type of  financial company, and you buy a bunch of U.S. Treasury bonds or mortgage-backed securities. Your money is tied up in those investments … but not if you can borrow against them on the repurchase market the same day and get most of your cash back. Suddenly you have money to do another deal.

Or maybe you’d like to buy some U.S. Treasury bonds or mortgage-backed securities, so you can collect the interest they pay, but you don’t have the money to buy them. One way to get that money is to take out a repo loan, using the cash to buy the securities, and using the securities to collateralize the loan.

Repos are quick money,[42] and they’re cheap money, too.  Because repo is secured, [43] the overnight repurchase rate is often lower even than the Fed Funds rate,[44] which is the rate banks charge each other to lend money they have on deposit with the Federal Reserve. [45] And since a repo loan is often rolled over, or refinanced, when it comes due,[46] a one-day loan can actually last for months.[47]

But check out the leverage in that repo. (Editor’s note: Leverage means borrowing money in hopes that you can use it to earn more than it’s costing you.) You’ve borrowed almost the entire cash value of the securities, and you’re going to use that money to do another deal. That means those assets, those bonds, which you still own even though you’ve temporarily “sold” them,[48] are now heavily leveraged.

Most of the leverage in the shadow banking system at the time of the financial crisis was repo loans, according to New York University economists.[49]

And there’s more. The financial institution that lends you the money and gets the securities can often reuse the securities as collateral for its own repo loan and get its cash back, too. As can the next lender, and so on[50] – creating a chain of debt. 

Throughout the chain, the securities still belong to you.[51] You get the profit if their price rises, the loss if it falls and all interest payments.[52] If the price falls during the repo, your lender can immediately demand that you post more securities as collateral or put up cash, a feature that caused chaos during the crisis.

Repo lenders[53] are mainly money market funds[54] but also other mutual funds, states, municipalities, pension funds, foundations, insurers, asset managers and businesses[55] that need a quick, safe place to deposit large pools of cash. If Americans review the holdings of their money market fund, community bank,[56] or pension plan, they will likely find repurchase agreements in their portfolio. Other large repo lenders are agencies like Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

Repo borrowers were mainly investment banks like Lehman Brothers and Bear Stearns before the crash. Other repo borrowers[57] are broker-dealer subsidiaries of bank holding companies, large commercial banks,[58]hedge funds, Fannie and Freddie, mortgage lenders like Countrywide Financial Corp.,  and community banks.[59] Daily, their repo desks sweep up loans and securities holdings from every corner of their company and turn them into cash.

Typically, repo borrowers use the money to make business and consumer loans,[60] or to invest or speculate, or they hold onto the cash to make their company look financially strong to regulators, investors and the public.

Many financial institutions, in actual practice, are both repo lenders and borrowers.

Industrial companies also use the repo market, to augment their daily cash flow needs,[61] and central banks use it to effect monetary policy by adding or subtracting money from circulation.[62]

Over the years, repos have evolved into a mature, sophisticated and highly developed industry. [63] As demand for repo grew, the market needed more collateral. Where would it come from?

Securitized banking

Securitization was one answer. In the years leading up to the financial crisis, securitization became a source of collateral for repo[64] and repo became a source of financing for securitization.[65]Economist Gorton calls the combination securitized banking. Here’s how it worked:

In securitization, financial institutions made or bought millions of consumer and business loans, including mortgages, credit cards debt, car loans, business loans, student loans, commercial real estate loans and much more,[66] even loans for time shares and motor homes.

They sold the loans to off-the-books businesses, or trusts, that they or others had set up. The off-the-books businesses pooled[67] the loans and created asset-backed securities (ABS) that were backed by the cash flow of the loans. Credit rating agencies gave many of these securities high marks – higher than if the financial institutions themselves had created them, because the securities were protected by the off-the-books businesses from any trouble that might develop at the originating financial institution.[68]

In 10 years through 2007, the off-the-books businesses issued $23 trillion[69] in asset-backed securities,[70] according to the Securities Industry and Financial Markets Association, a trade association. They sold these securities to money market funds, commercial and investment banks, securities dealers, pension funds, insurance companies, mutual funds, municipalities, community banks, hedge funds and other investors who held them as portfolio investments.

Increasingly, some institutions used these securities as collateral for repo loans.[71]The higher the securities were rated, the more cash they could get from a repo lender. With that cash, some of the firms then made or bought more consumer and business loans,[72] to pool and produce more securities, to use as collateral for more repo loans. 

It was a neat, self-sustaining cycle of profitability [73] and a serious growth machine.

Institutions also used repo loans to buy securities, and used those same securities as collateral for the repo loans. In other words, the repo loan financed the bank’s purchase of the repo collateral.

Securitized banking, then, is the combination of the repurchase market and securitization, where institutions use repurchase agreements to finance much of the business of securitizing loans and holding securities.

“This banking system ‐‐ repo based on securitization ‐‐ is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy,” said Yale professor Gorton in testimony to the Financial Crisis Inquiry Commission in February 2010.

Financial institutions also used the asset-backed securities as collateral for derivative transactions[74] and other trading purposes,[75]  making them a critical cog in the wheel of finance.

Commercial banks have repoed for decades, [76] but they rely less on repo financing than some other institutions do, because they have deposits. Still, deposits have disadvantages: Banks have to hold reserves against deposits,[77] banks can’t grow beyond 10 percent of national deposits,[78] and at times[79] banks have to pay for FDIC insurance on deposits. Other financial institutions do not have access to deposits and rely more on repo. These include broker-dealers, investment banks, mortgage lenders, hedge funds, Fannie and Freddie.

Commercial banks have been able to securitize loans since 1989, when an appeals court ruled that securitization does not violate the Glass-Steagall Act that separated commercial and investment banking.[80]

Between 2000 and 2005, several developments made the combination of repo and securitization especially profitable for the financial industry and inflated a repo-and-securitization bubble:

-In 2000, Financial Accounting Standards Board Statement 140 modified earlier rules on how companies could securitize[81] and laid the groundwork for a robust securitization industry.[82] The next year securitization doubled, and in three years it tripled.[83]

-In 2001, the Fed dramatically dropped short-term interest rates after the dot.com and telecom busts,[84] and it took historic steps to keep the stricken repurchase market alive after the terrorist attacks of 9/11. [85]This made repos even more profitable. For the next three years, companies could get a repo loan for 1 percent to buy mortgage securities paying 4 percent and more.[86] It also signaled that the Fed would do whatever it took to protect the repurchase market. The next year repo rose 14 percent and in three years it was up 60 percent, based on the activity of the biggest dealers.[87]

-In 2001, 2004 and 2005, regulators approved critical changes in banking, accounting and bankruptcy laws that made repo and securitization steadily more attractive,[88] by making it easier for financial institutions to get repo collateral,[89] cheaper for them to securitize[90] and safer for lenders to make a repo loan.[91] (See the Road to Ruin tab on the RepoWatch home page for details.)

The result was a repo boom that strained the market.

Traditionally, repos had used U.S. Treasuries, quality mortgage securities and other high-grade bonds for collateral, but as early as 2001 there was a shortage.[92] Financial institutions began turning to their mortgage machines[93] for ever and ever weaker collateral. By 2005[94] repo collateral even included securities made from tranches[95]  of particularly complex off-the-books businesses called collateralized debt obligations (CDOs). [96] Some of these CDO tranches were made from subprime mortgage securities, some from slices of other CDOs and some were even made from credit default swaps on the CDO securities. [97]

Credit default swaps (CDSs) are derivative contracts that are supposed to pay off when a CDO security or other debt goes into default. They’re like insurance, but without the reserves that insurance companies have to put aside to pay claims. Credit default swaps played a critical role in the housing boom in part by insuring otherwise low quality mortgage-backed securities, getting a high rating for them and making them attractive repo collateral – especially after June 2005 when the International Swaps and Derivatives Association published a standardized contract that made CDS easy to use.[98] By giving securities holders and regulators a false sense of safety, CDS contributed to the housing bubble.

At its extreme, the credit chain could look like this: Home loans got pooled with thousands more home loans. That pool got pooled with other pools. Then credit default swaps were issued on the pools of pools, and those credit default swaps themselves got pooled and turned into a security. A financial institution bought that CDS-backed security and repoed it out to another financial institution that re-repoed it to someone else. And all of that happened on the back of the original home loans.

Alhough the number of home loans might be limited by the number of people wanting a loan, the number of credit default swaps had no such limit. Eureka. An unlimited supply of repo collateral.

Hundreds of service firms[99] – many of them affiliated with giant financial institutions and each other[100] – sprung up to make, service and insure the home loans; to create and manage the loan pools; to create, sell and insure the securities; to broker, trade, match, enforce, document, guarantee, net and clear the repo transactions; to broker, hold, manage, value, insure, invest and adjust the repo collateral; and to lawyer and audit it all.

Between 2002 and 2008, repo markets in the U.S. and Europe each doubled in size, according to the Bank for International Settlements, which coordinates worldwide financial regulations from its headquarters in Basel, Switzerland.[101]

Then in June 2007,[102] after subprime homeowners began to default, repo lenders panicked over the quality of the mortgage-backed securities that served as collateral[103] for about 20 percent of their loans. While subprime was only 12 percent of all U.S. mortgages at that time,[104] and CDOs were only 6 percent of all asset-backed securities outstanding,[105]repo lenders couldn’t tell where the ticking time bombs were.

At first, they demanded more collateral, more securities or cash. This is known in the industry as making a margin call or raising the haircut.[106]

One of the great flaws of repurchase agreements is that if the lender believes the value of the collateral securities has become inadequate to secure the loan, the repo lender can demand more collateral or repayment of part of the loan, long before the loan actually comes due. Thus, a borrower that will have no trouble repaying the loan when it comes due, yet doesn’t have extra cash in the meantime, can be crushed by a lender’s demands for more collateral during the life of the loan.

As troubles mounted in 2007, repo lenders lost faith in all of the securities, not just those backed by mortgages,[107] and, more importantly, they lost faith in shadow finance,[108] especially the heavily leveraged investment banks and the commercial banks that together were discovered to be holding one-fourth of the mortgage-backed securities they’d supposedly sold to investors.[109]

Surprisingly, financial institutions that said they used securitization to offload risk to investors had actually done just the opposite, by holding many of the securities themselves.[110]

In other words, they had plenty of skin in the game. 

It was the repo lenders who did not.[111] They demanded their money back. Even when the collateral was super-safe U.S. Treasuries, repo lenders wanted out.[112]

At the time, Lehman, Bear and other top U.S. investment banks had repo loans on roughly half of their assets.[113] Lehman was borrowing $230 billion every night in the repurchase market.[114] Daily, the big investment banks were rolling over one-quarter of their financing,[115] much of it[116] in repos.

The demands from repo lenders forced these heavily indebted companies into panic sales of their holdings to try to raise money, driving down the value of a broad range of securities, not just those backed by mortgages.[117] 

Repo borrowers couldn’t even protect their securities from fire sales by filing bankruptcy, because Congress has stipulated that bankrupt borrowers must let repo lenders keep the collateral.[118] The purpose[119] was to prevent trouble in one firm from spreading to others – in other words, to prevent systemic risk – but in the financial crisis it forced a devastating drop in security values,[120]as frightened repo lenders seized collateral and sold it without caring if their actions caused repo borrowers to go bankrupt.

In 2007 and 2008, the run on repo slashed repo funding in the U.S. by almost half. [121] That cut off key financing for credit markets worldwide and strangled not just housing but much consumer and business lending.[122]

 Repo, then, was an important way that defaults in the housing market became a full blown credit panic. It was a key transmitter that carried the shock wave from the defaulting homeowner through the canyons of Wall Street to the American taxpayer.

“This helps explain how a relatively small quantity of risky assets was able to undermine the confidence of investors and other market participants across a much broader range of assets and markets,” Geithner said in a June 2008 speech about systemic risk.[123]

Another driver of systemic risk during the crisis was derivatives,[124] mainly credit default swaps,[125]regulators said. The federal government’s $182 billion rescue of AIG was in part a response to regulators’ worry that AIG would not be able to honor its $527 billion in CDS contracts[126] and their uncertainty about who would be affected.

Runs on the banks

The repo flight, which began in June 2007[127]and climaxed in September 2008, was the first systemic bank run in the United States since the 1930s,[128] as repo lenders “ran” to repo borrowers to get their money back.

Unlike the bank runs by depositors a century ago, this run was invisible to ordinary Americans until near the end, because it occurred in a tangled web of trillions of dollars of transactions among global financial institutions.  But it was just as devastating.

In addition to the run on repo, runs also developed in other corners of Wall Street’s shadow banking system.

Seeing repo lenders pull back,[129]buyers of asset-backed commercial paper (ABCPaper) panicked. ABCPaper is a short-term, often overnight, IOU[130] that banks and their off-the-books businesses[131]sold to investors such as money market funds to raise cash for the banks’ securitization operations.  It was a leading source of financing for securitization.

ABCPaper also became part of the repo chain when ABCPaper sellers used the cash proceeds to make repo loans and when ABCPaper buyers used the ABCPaper as collateral for repo loans.[132]

ABCPaper peaked in July 2007[133] at $1.2 trillion[134] outstanding and then began to falter amid subprime worries. Investors who had regularly renewed their purchase of short-term ABCPaper suddenly refused to renew. Like repo lenders, ABCPaper investors could run, and in 2007 and 2008 many did,[135] particularly in late 2007. The run heavily damaged securitization and devastated Citigroup, the largest creator of the off-the-books businesses among commercial banking holding companies. At Citigroup, these businesses were called structured investment vehicles, which later became infamous in the press as SIVs.

Then in September 2008 – when Lehman failed, Congress refused to pass a bank bailout bill, and repo seized – investors also ran from unsecured commercial paper which large companies sell to finance their operations, from derivatives which traders use to hedge risk and speculate, and from shares of money market funds.[136] All are short-term investments, vulnerable to panic. Their implosion threatened the solvency of the nation’s businesses and families.

Fear also hit the securities lending market, a smaller[137] cousin to the repo market, where financial institutions lend their stock[138] holdings[139]in return for cash. The securities lender can then reinvest that cash, often in repos, until the securities borrower wants the cash back.[140] Securities borrowers are often securities dealers and speculators who need the borrowed stocks for trading purposes.[141]

In the financial crisis, spooked securities borrowers demanded their cash back. That was a problem for securities lenders who had used the cash to make repo loans[142] collateralized by mortgage-backed securities and CDOs,[143]or who had used the cash to buy the risky bonds outright. With the bonds falling in value, the securities lenders were going to have to make up the difference when the securities borrowers wanted their cash back.

At AIG, taxpayers had to pay $43.7 billion[144] to securities borrowers, only $6 billion[145] less than the better-known payouts on AIG’s credit default swaps.[146] At California pension giant CalPERS, securities lending caused $284 million in real losses and $658 million in paper losses in fiscal year 2008-2009.[147]

These runs in the shadow banking system decimated securitization, which had been providing half the credit in the U.S.[148] It fell 44 percent between 2007 and 2008, according to the Securities Industry and Financial Markets Association.[149]  With the fall vanished $1 trillion a year in loans for cars, commercial real estate, credit cards, small businesses, many other consumer and business needs and, of course, for mortgages.[150]

With it also vanished the popular notion that mortgage securitization was a beneficent money machine, with home lenders selling mortgage-backed securities to investors so the lenders could recoup their money and make more home loans. In that scenario, the investors would have had big losses in 2007 and 2008, like dot.com dreamers did in 2000 and 2001, but there would have been no run on the banks.[151] What that cozy story line left out was that much of the money belonged to repo lenders and ABCPaper investors who could take it back at any time. And they did.

No one should have been surprised that financing long-term mortgages with short-term money was dangerous,[152]  some experts said.

Although U.S. banks haven’t seen a broad bank panic since the FDIC started insuring their deposits in 1934,[153] maturity mismatches have caused problems for many borrowers through the years, such as Penn Central railroad using unsecured commercial paper in 1970,[154] Franklin National Bank using repurchase agreements in 1974,[155] Continental Illinois Bank using brokered deposits from abroad in 1984,[156] savings and loans using brokered deposits in the late 1980s, Orange County, California, using repurchase agreements in 1994,[157] and Long Term Capital Management hedge fund using repurchase agreements in 1998.[158]

“Banks should have learned by now it’s dangerous to rely on overnight lending,” economics professor Allan Meltzer told Bloomberg last year.[159] Meltzer is a professor of political economy at Carnegie Mellon University in Pittsburgh and author of a three-volume book on the Fed.

Yet repos are returning.

The repo market in the U.S. is still 40 percent below the peak in March 2008, [160] mainly because companies are wary. But it’s up more than 20 percent from its September 2009 bottom, according to the activity of the biggest dealers.[161] In Europe, repo was higher in 2010 than it was in 2008. [162]

Hedge funds[163] and money market funds[164] are stepping up their repo activity, and some money market funds have begun accepting nongovernment securities as collateral, to get a higher rate of return and to compensate for a shortage of safer collateral,[165] according to industry reports.

Missing from the action is securitization.[166] Almost the only mortgages being securitized are those guaranteed by the American taxpayer through agencies like Fannie and Freddie.[167] Annual issuance of other loan securitizations – such as auto, credit card, home equity lines, students and businesses – is still down more than 80 percent, more than $600 billion, from its peak in 2006, according to industry data.[168] Of these, only auto, business[169] equipment lines and commercial real estate[170] show decent signs of revival.[171] Small business loans insured by the Small Business Administration[172] are stirring.

The uncertainty of repo funding and securitization, known together as securitized banking,  raises serious questions about how the U.S. economy will grow its way out of the current downturn.[173]

“Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created,” Yale professor Gorton told the Financial Crisis Inquiry Commission.

Daunting challenges ahead

For securitized banking[174] to regain its critical role in modern finance, some experts[175] say repo must address daunting challenges:

—-Repo depends on trusted collateral.[176] In the past decade, a good supply of highly rated collateral made repo loans safe for lenders and cheap for borrowers[177] …. until 2007 when some of the AAA-rated collateral turned out to be junk. Some supporters warn that if securitization does not revive, there could be a shortage of repo collateral when the economy picks up, when the current supply of Treasuries recedes,[178] or if foreigners buy up the good collateral.[179] On the other hand, if securitization does return, so could the risk, if memories fade and lenders once again accept the word of rating agencies that a subprime mortgage security is AAA,[180]or that all sovereign debt, municipal bonds , small business loans[181] and commercial real estate loans[182] make fine collateral.

In May 2010, the repo market in Europe – increasingly popular with U.S. money market funds[183] – got a taste of the possibilities[184] when Greece’s debt problems caused repo parties to panic over sovereign debt collateral and the European Central Bank had to intervene.[185] In November 2010, the scenes replayed with Irish debt as the troublesome collateral.[186] By 2012 all European sovereign debt was suspect.

—-Repo reeks of systemic risk. Although thousands of financial institutions borrow and lend via repo, 21 companies – the so-called Primary Dealers[187] approved to repo with the New York Fed – are thought to do about 90 percent of the business,[188] although no one knows for sure. These global giants are the most influential players in the U.S. repo market, as they help the New York Fed’s trading desk buy and sell securities on the repurchase market and they supply Fed traders with market information and analysis. They were the primary bankers whispering in Geithner’s ear when he headed the New York Fed in the years leading up to the financial crisis, and they continue in that role today. They also make most of the nation’s home loans, do most of the derivative trading and hold much of the country’s savings. Plus, they borrow from each other, lend to each other, invest in each other, bet on each other, insure each other, trade with each other, clear for each other, buy from each other and broker for each other.[189]

This set-up for systemic risk is amplified by rehypothecation, [190] which means that the party who receives the repo collateral can often[191] re-use it. For example, if a hedge fund borrowed money from Lehman Brothers[192] and put up securities as collateral, Lehman’s traders[193] could then turn around and use those securities as collateral for their own repo loan from Bear Stearns,[194] which could then repo out the same securities to JP Morgan Prime Money Market Fund, and so on.

When Lehman Brothers declared bankruptcy, a European unit had reused $22 billion of the $40 billion in securities it held as collateral for repo and other loans[195] made to hedge funds.[196]  Bear Stearns, in its last quarter, reported it had $399 billion in assets, of which $303 billion were securities it had taken in as collateral for loans. It had re-used $211 billion of those securities.[197] JP Morgan Chase, at the end of last year, reported it had $2 trillion in assets and was reusing $393 billion of the $614 billion in securities it held as collateral for repos and similar transactions.

Repo deals are tangled transactions that commonly look like this:[198]

-A financial institution can buy securities from a bank and then use those securities to get a repo loan from the same bank. Looked at another way, the financial institution can get a repo loan from a bank and use the money to buy securities from the same bank.

-A financial institution can make or buy home loans, sell them to a trust that turns them into securities, buy the securities, and use them as collateral for a repo loan.[199]

-A financial institution that wants to buy some securities without spending any of its own money can buy them with a repo loan collateralized by the securities it plans to buy. In other words, the repo loan finances the bank’s purchase of the repo collateral.

-A trader can borrow securities in a repo transaction and sell them short – that is, sell them at today’s price, hoping to buy them tomorrow at a lower price and then unwind the repo.[200] Or, the trader can sell securities short and use that cash to borrow the shorted securities on the repo market. Tomorrow he will return the repoed securities, get his cash and buy the shorted securities. Short sales are a key reason financial institutions buy securities on the repurchase market.

-A bank can make a repo loan to a borrower, who will use the money to buy the repoed securities from the same bank, and the bank will reuse the securities as the collateral for a repo loan for itself from someone else. [201]

-If repo conditions are right, a trader can take out a repo loan at one rate and use that cash to make a repo loan at a higher rate.[202]

-Repos are important elements of derivatives transactions. For example, if a trader buys an option and hedges it by buying the underlying bond, the trader might get a repo loan to pay for the bond, using the bond as collateral for the repo loan. Derivative markets could not have exploded as they have in recent years without repo financing.

Ralph Cioffi, who ran hedge funds for Bear Stearns, told the Financial Crisis Inquiry Commission how he used repo and securitization profitably for his hedge funds until June 2007:

He said he used 10 percent investor money and 90 percent repo loan to get the cash to buy securities. He said he might get the repo loan and the securities from the same securities dealer. Cioffi then sold those securities to a CDO – or, later, synthetic CDOs and CDOs squared – and he used those proceeds to pay off the repo loan. The top tranches of the CDO were asset-backed commercial paper, which he sold to raise cash for the CDO.   

Listen to him tell the story in his own words here.

Repo, often privately transacted and unmonitored, is vulnerable to fraud and abuse. Some examples:

-A federal grand jury in Virginia in June accused the CEO of Taylor, Bean & Whitaker Mortgage Corp. of Ocala, Fla., one of the nation’s largest non-bank mortgage lender,[203] of using repo to run a $1.9 billion fraud scheme. TBW is accused of pledging fake home loans and fake mortgage-backed securities as collateral for repo loans from now-defunct[204]Colonial Bank, based in Montgomery, Ala. TBW also sold the same fake securities to an off-the-books business it created, which then sold them to Fannie Mae, Freddie Mac and two major European banks, according to prosecutors who claim the complexity of the securities made the fraud difficult to detect. (Editor’s Update: A jury found the CEO guilty of bank fraud April 19, 2011. The CEO testified that repo fraud “happens all the time.”)

-Examiner Anton Valukas in the Lehman Brothers bankruptcy has accused that company of using the now-infamous Repo 105 and Repo 108 accounting shams to hide debt. Lehman reported the transactions as sales, when they should have been reported as collateralized financings, a type of debt. Citigroup and Bank of America have admitted similar deck shuffling, all done in innocent error, they said.[205]

-Valukas also reported that Lehman misrepresented repo transactions[206] to make it falsely appear Lehman had $32.5 billion in securities it could quickly sell to repay lenders and investors in a crisis, and thus had plenty of liquidity. Actually it had only $2.4 billion.[207] Most of the difference was collateral it had privately pledged for trades, at least half of  which[208] were repo loans, Valukas reported.

-Insider deals can take several forms, according to critics. Here are two:

A bank wants to get rid of some troubled mortgage securities that no one will buy? No problem. The bank makes a repo loan to a friendly investor. Then the friendly investor uses the repo-loan money to buy the troubled securities from the bank, and then uses the troubled securities as collateral for the original repo loan from the bank. In other words, the bank pays an investor to take the bank’s troubled mortgage securities. The investor gets a fee.

A troubled bank needs AAA-rated securities to satisfy demands from a repo lender for more collateral? No problem. The bank gets a repo loan from a trust, using troubled real estate loans as collateral. The trust pools and tranches and turns the loans into AAA securities. The bank uses the repo loan from the trust to buy the AAA securities from the trust. The bank then uses the AAA securities to meet the collateral demands. In other words, the bank pays the trust for the bank’s own loans that have been sanitized. The trust gets a fee.

-Working their way through the courts are civil lawsuits filed by various repo borrowers against some of the nation’s biggest-name repo lenders, claiming the lenders broke repurchase agreements at will. Borrowers typically allege that lenders falsely claimed the value of repo collateral had declined, forcing borrowers to put up more securities or cash as collateral. Chaos in the market is making it hard for plaintiffs to convince courts that the lenders knowingly lied about collateral values, but the cases are showing the potential for abuse by repo lenders.

In spite of these complexities, much of the financial world thought the repurchase market was safe.

 “Until recently, short-term repos had always been regarded as virtually risk-free instruments,” Federal Reserve Chairman Ben Bernanke told a meeting of bankers in May 2008, after nine months of turmoil in the repo market.[209]           

Former Federal Reserve Chairman Alan Greenspan, writing in an April report on the panic, described repos as “almost sacrosanct.”[210]

Charles Munger, investor Warren Buffett’s partner, had a different view, as he told the Stanford Lawyer last year:[211]

“Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the ‘repo’ system – one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome.

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**Repos differ from collateralized loans in several important ways. Here are some:
-Lenders can call for more collateral at any time. That’s what caused the financial crisis in 2008. Even if a borrower can repay the loan when it’s due, he can be ruined by margin calls in the meantime.
-The lender holds, has control of, and can reuse the collateral during the life of the loan. He can sell it, short it, use it for a repo loan, whatever. And because the lender holds the collateral, he’s positioned to sell it quickly and get his money back if the borrower defaults or goes bankrupt. He doesn’t get tied up in a bankruptcy. Lenders love this, but it encourages them to go light on their due diligence.
-Commercial and investment banks don’t have to report repo totals lent or borrowed. Instead, they report the net amount per counterparty. So we don’t really know what’s going on.
-Repo collateral doesn’t have to be specific securities. It can be a claim on a basket of securities.
-Repos are protected by the Federal Reserve, which relies on the repurchase market for executing its monetary policy.

Editor’s Note:  I collected the following footnotes for my own use, to help me keep track of some of  my online sources. I left them here in case they’re helpful to you, too, even though over time some documents get moved and the links no longer work.