This is a slightly longer article than usual but it is about the fifth anniversary of a major economic collapse.
By GRETCHEN MORGENSO
IT’S been five years since the bankruptcy filing of Lehman Brothers set off the worst economic crisis in the United States since the Great Depression. With the perspective that distance provides, it’s worth asking: Is our financial system safer and sounder today than it was back then?
Many of the nation’s bankers, lawmakers and regulators might well say
yes, arguing that safeguards have been put in place to protect against
another cataclysm. The voluminous Dodd-Frank law, with its hundreds of
rules and new regulatory regimes, was the centerpiece of these efforts.
And yet, for all the new regulations governing derivatives, mortgages
and bank holding companies, a crucial vulnerability remains. It’s found
in our vast and opaque securities financing system, known as the
repurchase obligation or repo market. Now $4.6 trillion in size, it is
where almost every financial crisis since the 1980s has begun. Little
has been done, however, to reduce its risks.
The repo market, also known as the wholesale funding market, is the
plumbing of the financial system. Without it, money could not flow
freely, and banks, brokerage firms and asset managers would not be able
to conduct their trades and open for business each day.
When institutions sell securities in this market, they do so with the
promise that they can be repurchased the next day — hence the “repo
market” name. By using this market, banks can finance their securities
holdings relatively cheaply, money market funds can invest cash
productively and institutions can borrow securities so they can sell
them short or deliver them in other types of trades.
Among the biggest participants that provide funding in this market are
the money market mutual funds; they lend their cash to banks and other
institutions, accepting collateral like mortgage
securities in exchange. The money market funds accept a small amount of
interest on these overnight loans in exchange for being able to unwind
the transactions daily, if need be.
When markets are operating smoothly, most wholesale funding trades are
not unwound the next day. Instead, they are rolled over, with both
parties agreeing to renew the transaction. But if a participant decides
not to renew because of concerns about a trading partner’s potential
failure, trouble can arise.
In other words, this is a $4.6 trillion arena operating on trust, which can disappear in an instant.
Both Bear Stearns and Lehman Brothers collapsed after their trading
partners in the repo market became nervous and stopped lending them
money. For decades, the firms had financed their holdings of illiquid
and long-term assets — like mortgage securities and real estate — in the
overnight repo markets. Not only was the repo borrowing low-cost, it
also allowed them to leverage their operations. Best of all, accounting
rules let repo participants set aside little in the way of capital
against the trades.
“It was a very unstable form of funding during the crisis and it is
still a problem,” said Sheila Bair, former head of the Federal Deposit
Insurance Corporation, and chairwoman of the Systemic Risk Council,
a nonpartisan group that advocates financial reforms, in an interview.
“The repo market is also highly interconnected because the trades are
done between financial institutions.”
Some government officials have also voiced concerns recently about risks
in the repo market. William C. Dudley, president of the Federal Reserve
Bank of New York, referred to the issue in a February speech and Ben S. Bernanke, the Fed chairman, discussed the problems with wholesale funding in a speech in May. The Securities and Exchange Commission published a bulletin in July on the vulnerabilities in the repo market as they relate to money market funds.
Another problem in this market is that only two banks — Bank of New York Mellon
and, to a lesser degree, JPMorgan Chase — dominate the business. There
used to be a number of clearing banks, as the banks that stand in the
middle of the trades are known, but the ranks have dwindled because of
industry consolidation.
Unfortunately, these weaknesses remain. “A lot of things have been done
to address a lot of specific problems but it doesn’t seem like anything
has been done to address the overall problem of institutions losing
access to financing,” said Scott Skyrm, a repo market veteran and author of “The Money Noose — Jon Corzine and the Collapse of MF Global.”
Mr. Skyrm said regulators appeared to be tackling the problem through a
back door involving capital requirements. For example, new leverage
ratios proposed by the international Basel Committee and United States
financial regulators would require banks for the first time to set aside
capital against the assets they finance in the repo markets. A recent
report from J.P. Morgan
estimates that under the Basel proposal, the eight largest domestic
banks would have to raise $28 billion to $34 billion in capital relating
to their repo business.
Banks are likely to consider an alternative: shrinking their repo
operations. But the liquidity in this titanic market is essential for
the government’s financing of its debt. As the J.P. Morgan report noted,
trading volumes in the United States government bond market are closely
linked to the amount of repos outstanding. So any contraction in the
arena may reduce liquidity in the Treasury market.
SOME experts think that the answer to the repo problem lies in creating a
central clearing platform that would allow all participants, not just
the banks, to trade directly. Similar platforms have been mandated for
derivatives under Dodd-Frank and could be constructed to support the
wholesale funding market.
While such an entity would be a too-big-to-fail institution, so are the
two banks now serving as intermediaries. And a central clearing platform
could be set up as a utility, with officials monitoring transactions
and requiring margin payments to finance bailouts in the event of a
participant’s default.
Peter Nowicki, the former head of several large bank repo desks, is an
advocate of this idea. “Repo is the last over-the-counter market that’s
not headed toward central clearing and the Fed should mandate a change,”
he said. “Should a large dealer have a problem or the clearing banks
have an issue, the repo market could shut down.”
And that, five years after the Lehman collapse, would be an unconscionable failure.
