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The Repo Market

Yale's Gary Gorton -- gah, so much bold! -- has an interesting new paper called "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007."

Gorton's paper attempts to explain the "where" of the panic. The banks didn't fall because individual investors lined up on the street for an old-fashioned bank run. They fell because other banks concocted a new sort of bank run. This happened, Gorton says, in the "sale and repossession market" (the repo market), where large institutional investors deposited big chunks of short-term cash and banks insured that cash by offering collateral -- a senior tranche of securities, say -- in return.

When the subprime crisis hit, this all fell apart, and fast. "Uncertain about the solvency of counterparties, repo depositors became concerned that the collateral bonds might not be liquid; if all firms wanted to hold cash – a flight to quality — then collateral would have to decline in price to find buyers. This is the crucial link between the subprime shock and other asset categories." Here's the key graph:


"The size of the haircut reflects the credit risk of the borrower and the riskiness of the pledged collateral," Gorton writes. As the crisis wears on, the system judges the collateral (in this case, structured debt) to be riskier and demands much larger haircuts. Suddenly the depositor is offering only $85 for collateral worth $100 in today's market. The reason is simple enough: He's worried that the collateral will only be worth $50 in tomorrow's market. The $15 difference is his price on the risk. But if the banks can't borrow as much off the same pool of collateral, they have to finance their balance sheet some other way. Like selling assets. Which depresses asset prices. And so we're off to the (recessionary) races.

But the telling bit of that chart, as Steven Pearlstein pointed out to me, is not the area where the line jags upward. It's at the beginning, where it hugs the X axis. That's where the system thinks itself effectively invulnerable: where the people buying structured debt are not asking for any risk premium. Where they aren't building in any serious risk of default or decline. Where they're treating collateral almost like cash. Like there was no chance any of this could happen.

(Via Tyler Cowen.)

By Ezra Klein  |  May 19, 2009; 7:05 AM ET
Categories:  Financial Crisis  
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I'm glad they added your blog. I like it!

Posted by: caroleg1 | May 19, 2009 8:09 AM | Report abuse

How nice of your mother to log on this early...

About the article, just another example of greed gone wild. Nobody wants to bring up the huge commissions these people were raking in for trading this carp among themselves. And somebody thinks we need to pay them these huge bonuses to keep them around. They should be paying us back.

Posted by: Fredneck2 | May 19, 2009 8:49 AM | Report abuse

"Where they aren't building in any serious risk of default or decline. Where they're treating collateral almost like cash. Like there was no chance any of this could happen."

Ezra, it's not entirely clear from your post whether you realise this, but it's important to remember that repo trades are margined, typically on a daily basis. So if the value falls by more than a certain threshold amount, the "seller" has to put up more collateral. And of course, even if the collateral defaults or falls to zero, the "seller" is still on the hook for the whole cash amount. So it's not strictly true to say that they weren't building in any serious risk of default or decline. They weren't building in any serious risk of default or decline combined with the default of the "buyer". It's also worth noting that, at least since the crisis hit, repo trades have been very short term - overnight to a couple of weeks in most cases. So even with a subprime RMBS, the chances of it going from AAA to defaulting are pretty damn slim.

But the essence of the repo market is that it's supposed to be as riskless as interbank lending gets, hence the large haircuts.

Posted by: GingerYellow | May 19, 2009 7:13 PM | Report abuse

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