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)