Repo – A New Type of Banking
- A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is short-term, receives interest, and is backed by collateral. Depositor takes legal ownership of the collateral.
- Carved out of Bankruptcy Code; unilateral termination by non-defaulting party.
- Two types of repo: bilateral and tri-party. Both types caused trouble in the crisis.
- Collateral may be “rehypothecated”.
- Collateral value typically exceeds the amount of cash deposited, this is called a haircut For example, deposit $98, receive a bond worth $100—a 2% haircut.
- As of March 2008, the situation at Lehman Brothers was just as precarious as it was at Bear Stearns, and perhaps Lehman only survived longer than Bear because some shady accounting made them look better than reality.
- After the government-supported rescue of Bear Stearns in March 2008, the Federal Reserve created the Primary Dealer Credit Facility (PDCF) to provide liquidity to non-bank dealers like Lehman.
- The PDCF was critical to Lehman’s survival over the next six months, as they tried to get rid of their worst assets and improve their capital and liquidity position.
Lehman Weekend – September 2008
- On September 10, 2008, Lehman reported $28 billion in shareholder equity, $4 billion higher than a year earlier. But it was simply impossible to know if this equity cushion was accurate.
- For one thing, Lehman reported $54 billion in real estate assets. Some market participants thought the true value was closer to half of that, which would effectively wipe out Lehman’s equity.
- At the same time, Lehman’s counterparties in derivatives, commercial paper, and repo were pulling back, shortening terms, and demanding more collateral.
- Most notably, JP Morgan, Lehman’s clearing bank in the tri-party repo market, demanded $5 billion and received $3.6 billion on 9/9, and demanded and received $5 billion on 9/12.
Lehman Weekend – September 12-14, 2008
- Over the weekend of 9/12 – 9/14, the U.S. government tried unsuccessfully to arrange a private rescue for Lehman.
- The government insisted there would be no public money spent on the rescue.
- Bank of America chose to buy Merrill Lynch instead of Lehman.
- On Saturday, Barclays agreed to buy Lehman, but by Sunday the deal was effectively blocked by UK regulators.
- Without sufficient liquidity to operate the next day, and otherwise out of options, Lehman filed for bankruptcy early in the morning on September 15.
- Money-Market Mutual Funds (MMMFs) are a specific type of investment company that is only permitted to own a narrow range of securities. In return for accepting this narrow investment range, they had the right (at this time) to report “stable values” for their share prices.
- On September 16, 2008, Reserve Primary Fund “broke the buck” due to exposure to Lehman Brothers commercial paper. This led to a run on many MMMFs – mostly by institutional investors – and then quickly to an explicit guarantee from the U.S. government.
- We really should have seen this coming – but we did not. Because MMMFs had significant problems in August 2007 as a result of the Asset-Backed Commercial Paper (ABCP) runs.
- McCabe (2010) shows that MMMFs assets under management grew during the ABCP runs of 2007, but that is because the implicit promises of many sponsors were honored: 43 MMMFs were bailed out by their sponsors/fund-families. This level of support was unprecedented.
- In September 2008, this support was not possible, and the resulting runs transferred more than $400 billion from prime MMMFs (which support many components of private finance) to government-only MMMFs (which do not).
- Credit-default-swap (CDS) mark-to-market losses and collateral calls.
- Cash collateral investment losses in securities lending business.
- Funding pressure in CP and repo.
- Ratings downgrade triggers additional collateral calls.
- Liquidity puts on CDOs.
After Lehman, markets are in turmoil and no private rescue is possible.
Fed led rescue of $85 billion, later supplemented by more from Fed and TARP.
The Run on Repo
- $350 billion of short-term funding ran away from ABCP.
- From MMMFs, about the same amount.
- Combine these drains with uncertainty about the subprime exposure on balance sheets, and there is massive pressure on repo markets.
- This pressure manifests in spreads (on underlying ABS), repo rates, and haircuts.
- The statistical evidence in Gorton and Metrick (2012) confirms a significant relationship between LIBOR-OIS and ABS spreads.
- Regression evidence also suggests that the main driver of haircuts was uncertainty about future spreads on the ABS collateral.
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
The metal, which traded at $1,666.30 an ounce at 2:43 p.m. in London, may decline to as low as $1,475, the economist wrote today in his Suffolk, Virginia-based Gartman Letter. He sold the last of his gold yesterday. Bullion has already dropped 13 percent from the record $1,921.15 reached Sept. 6 and $1,475 would extend that to more than 20 percent, the common definition of a bear market.
“Since the early autumn here in the Northern Hemisphere gold has failed to make a new high,” Gartman wrote. “Each high has been progressively lower than the previous high, and now we’ve confirmation that the new interim low is lower than the previous low. We have the beginnings of a real bear market, and the death of a bull.”
The metal typically moves inversely to the dollar, which today reached a two-month high against the euro after Fitch Ratings and Moody’s Investors Service said yesterday that a European Union summit last week offered little help in ending the region’s debt crisis. Bullion is still 17 percent higher this year and holdings in gold-backed exchange-traded products are at a record, a hoard now valued at $126.5 billion.
Gold’s 2011 Gain
Gold’s performance this year compares with a 2.8 percent advance in the Standard & Poor’s GSCI gauge of 24 commodities, in which it is the third-best performer behind gasoil and cattle. The MSCI All-Country World Index of equities retreated 9.8 percent and Treasuries returned 9.2 percent, a Bank of America Corp. index shows.
The slump in equities spurred some investors to sell their gold to cover losses. Open interest, or contracts outstanding, in gold futures traded on the Comex exchange in New York, fell to 427,756 contracts, from 546,601 in July, bourse data show.
“So much damage has been done to the psychology of the market in the past week and so many late longs have been caught off guard that we think wholesale liquidation, and perhaps forced liquidation, shall be the outcome,” Gartman wrote.
ETP investors are increasingly bullish. Holdings in the products climbed 3.8 metric tons to an all-time high of 2,360.5 tons yesterday, according to data compiled by Bloomberg. That’s equal to more than 10 months of global mine supply and greater than the reserves of all but four of the world’s central banks, which are expanding holdings for the first time in a generation.
Hedge funds and other money managers boosted bets on higher futures prices for the first time in three weeks. Net-long positions in gold futures and options rose by 3.5 percent to 151,347 contracts in the week ended Dec. 6, U.S. Commodity Futures Trading Commission data show. That’s still down 40 percent since the beginning of August, when positions were at the highest level since at least June 2006, the data show.
While the drop below $1,670 spurred more physical buying from India and South East Asia, the demand increase is from “relatively low” levels, Standard Bank Plc wrote today in a report. UBS AG said its physical flows to India yesterday were “well above” average and the most since Oct. 20.
“This pullback finally encouraged a response from the physical community,” Edel Tully, an analyst at UBS in London, wrote in a report. “Market participants are placing a lot of importance on physical buyers to step in and put a floor under gold. The physical response seen this week, though not yet enough to call a trend, should somewhat calm these investors.”
In China, the second-largest consumer, gold imports to the mainland from Hong Kong surged 51 percent to 86.3 tons in October to a monthly record, according to the Census and Statistics Department of the Hong Kong government. China imported more than 300 tons for all of 2010, Yi Gang, People’s Bank of China Vice Governor, said in February.
“Buying of that sort should have sent gold prices soaring,” Gartman wrote. “One of the oldest rules of trading is simply this: a market that cannot or does not respond to bullish news is a bearish market not a bullish one.”
The S&P GSCI Index of 24 commodities plunged as much as 66 percent in the seven months through February 2009 after Gartman in June 2008 said there would be a “tidal wave” of selling. The economist said Aug. 23 that gold was entering the stage when prices go “parabolic,” two weeks before the metal peaked at its record high.