The Repo Market and the Start of the Financial Crisis

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The loss of liquidity at the firms that were the biggest players in the securitized banking system ...led to the financial crisis.

The financial panic of 2007-8 stemmed from a run on the repurchase or "repo" market -- the primary source of funds for the securitized banking system -- rather than a run on monetary deposits as in earlier banking panics, according to a recent study by Gary Gorton and Andrew Metrick. Repo is a form of banking in which firms and institutional investors "deposit" money, by lending for interest, short term, and receive collateral as a guarantee. The authors define "securitized banking" as the creation of structured bonds from bank loans, such as mortgages, which are then used as collateral for repo. In Securitized Banking and the Run on Repo (NBER Working Paper No. 15223), they argue that securities created from loans that originated in the subprime mortgage market played a major role in inciting the event, but that ultimately it was the loss of liquidity at the firms that were the biggest players in the securitized banking system that led to the financial crisis.

Prior to the panic, securitized banking was a $12 trillion business practiced by the nation's largest investment houses, including Bear Stearns, Lehman Brothers, Morgan Stanley, and Merrill Lynch, as well as by commercial banks such as Citigroup, J.P. Morgan, and Bank of America, as a supplement to their traditional banking activities. Buyers of securitized bonds, often made up of mortgages, receive protection from the seller in the form of a repo agreement: the investor buys some asset representative of collateral from the bank for a set amount and the bank agrees to repurchase that same asset some time later at an agreed upon price. The percentage earned by the investor on that collateral, which sometimes is made up of other securitized bonds, is analogous to the interest rate on a bank deposit; it is known as the "repo rate." Typically, the total amount of the deposit will be somewhat less than the value of the underlying asset, with the difference called a "haircut." That liability forces banks to keep some fraction of their assets in reserve when they borrow money through the repo markets.

The authors study spreads on 392 securitized bonds and related assets that are typically used in repo transactions. They track these market prices, over the period 2007-8. Among the market variables that they follow are ABX indices, which track the fundamentals of the subprime market, and the "LIB-OIS" spread, that is, the interest rate difference between the 3-month LIBOR (London Interbank Overnight Rate), which tracks the interest rate paid on unsecured interbank loans, and the overnight index swap (OIS) rate, which tracks the derivatives used in repo transactions. That LIB-OIS spread is believed to be a proxy for fears about bank solvency. Changes in the LIB-OIS spread represent counterparty risk, which is strongly correlated with changes in credit spreads and repo rates for securitized bonds.

Based on their analysis, the authors hypothesize that when the subprime real estate market weakened early in 2007, repo market buyers grew anxious about the quality of the securitized assets in the bonds and the increasing haircuts on deals. Although some banks raised capital by issuing new securities in response, those efforts soon fell short because of slumping real estate, and mortgage, prices. This was exacerbated by the forced selling of underlying collateral, which in turn reinforced the cycle of declining asset values and increasing haircuts. By August 2007, market fears reached a critical mass that led to the first run on repo. Lenders were no longer willing to provide short-term financing at historical spreads, and repo haircuts jumped to new highs, tantamount to massive withdrawals from the banking system. There was even a cessation of repo lending on many types of assets, and a rapid increase in the LIB-OIS spread signaled increasing danger in the interbank market.

While the authors cannot explain why these events occurred precisely when they did, they argue that this sequence of events put a crimp in the securitized banking cycle, which requires all steps to run without interruption in order to function smoothly. With shrinking equity bases stretched by increasing haircuts, even on highly-rated collateral, concerns about banks' liquidity came to the fore. In addition to dealing with the run on repo, banks were among the biggest investors in the market; they owned some of the bonds that they had created in the past, as well as recently-issued mortgages that they intended to securitize.

The next surprise to the industry was the government's forced rescue of Bear Stearns in March 2008. As the contagion spread to highly-rated credit securities unrelated to the subprime markets, the entire securitized-banking model came under increasing pressure. The ABX indices spread continued its steady rise, resulting in prices of pennies on the dollar for subprime securities. The rise in the LIB-OIS spread continued to record levels, which telegraphed the potential collapse of the interbank market.

In the second half of 2008, the full force of the panic hit asset markets, financial institutions, and the rest of the nation's economy. That ultimately contributed to the second systemic shock in September 2008, the failure of Lehman Brothers, the bailout of AIG, and the government takeover of Fannie Mae and Freddie Mac.

-- Frank Byrt