Sunday, 6 November 2011

Extreme Bank Runs in REPO Markets

Here is a primer on how repo markets relate to the conventional banking system.


In our financial system, a bank loan creates a bank deposit from "thin air". This deposit sits on the bank's books as a liability. The books are "balanced" by the loan agreement, which is an asset. 

A cashier's cheque drawn on the new bank deposit can buy your groceries in a way that the IOU from the borrower to the bank can not. You could say that the bank deposit has higher "moneyness" than the borrower's promise to repay. 

New money is created this manner as the borrowers promise to pay is "financialized". 

Physical cash has the highest "moneyness" (even more than the bank deposit). It is simply decreed to be money by the government's legal-tender laws.


A broader concept related to "moneyness" is "marketability". If legal tender laws did not exist,  the most marketable commodity would become money. People find it convenient to quote prices in terms of a marketable commodity. Financial transactions (including borrowing and lending) gravitate to using the most marketable commodity as money. 

Anything that is marketable can be used as money - metals, tobacco, salt, cowrie shells, beaver pelts etc have all been used. Historically, gold and silver were eventually adopted as money by the free market. If a shortage of the monetary commodity occurs (e.g. gold), people simply start using the next most convenient commodity as money (e.g. silver). 

Legal-tender laws ensure the marketability of cash - by requiring that taxes and other legal obligations be paid using paper money. However, the government can make any commodity money by "fiat" (decree).


Traditionally, financial regulations & prudential banking limited the amount of credit lent into the economy by a banking system - by tying it to the amount of CAPITAL in the retail banks. 

However, investment banks found a way to get around these limits to "financialization" using securitization. The securitization machinery at investment banks bought loans from retail banks and converted them to securities that were sold to investors. Retail bank capital was thus freed up to re-use lending channel to REPEAT this cycle and increase the credit in the system. The system was thus leveraged to many times the amount that would normally have been permitted by regulations. 

This arrangement may sound innocuous at first but it HYPER-LEVERAGES the investment banks' balance sheets. Every time investment banks securitize a batch of loans into investable tranches, they retained the riskiest portion of these loans on their own balance sheet. A small loss on these loan books had the potent to totally wipe them out. 

To mitigate this risk investment banks purchased CDS insurance on the safer tranches from reinsurers like AIG. However AIG itself underestimated the risk in these loans and was not capitalised sufficiently to write this insurance. 

This entire arrangement created a powder-keg ready to explode. The explosion happened in 2008 taking down Bear Sterns and Lehman brothers. AIG, Morgan Stanley, JP Morgan and Goldman Sachs would have disappeared too had the US taxpayer not massively recapitalized AIG, and twisted its arms to ensure that AIG paid the investment banks every last dollar of insurance due to them.


What is not well understand is that the purchase of a lot of these securitized assets was in fact funded indirectly by the retail banks themselves!! There is a MASSIVE lending market for REPOS between dealers and banks, wherein dealers pledge any asset that is valuable for loans from a bank. 

The newly created credit is lent out by the Prime Brokerage divisions of the investment banks to their customers, who buy risky assets. Depending on the potential volatility and liquidity of the pledged asset, the customers may be lent (say) 90%, or 80% or 70% of the value of the security, thus potentially leveraging their position enormously.


During periods of growth, increased confidence and competition amongst banks would cause creeping over-extension of loans to increasingly marginal borrowers. At some point marginal loans start to go bad. As this becomes known, the fear of bank runs starts to spread and the solvency of affected banks comes into question. 

If a bank's assets lost value (i.e. loans go bad) the books would become unbalanced and bank deposits could lose their "moneyness". Depositors became fearful and would try to to convert their deposits into cash, or transfer them into other banks. 

A distressed bank would attempt to restore confidence in the deposits by trying to raise cash through a combination of the following actions:

(a) Borrow money in the unsecured inter-bank market
(b) Pledge "marketable" assets in the REPO market
(c) Call in loans and pull credit lines, where possible
(d) Liquidate assets that can be sold, even if at a loss 
(e) Raise money in the capital markets through a share, rights or bond issue

The resulting curtailment of lending caused a "credit crunch" and liquidation of assets. This disrupted trade and manufacturing, giving rise to the business cycle

Central banks were created to try and "smooth out" the business cycle. They act as a lender-of-last-resort for distressed banks to provide them loans during a credit crunch. Central banks operate using REPO transactions. Banks pledge high-quality (i.e. "marketable") assets in exchange of central bank loans. Only the highest quality assets are usually accepted as "eligible collateral" for central-bank repos, otherwise the central bank may end up stuck with these if the bank becomes insolvent due to loan losses  

Central banks stipulate that banks maintain a minimum capital buffer to cover any loan losses. Accounting rules also mandate that any expected losses must be marked down in the books, curtailing further "risk-taking" (i.e. lending). Unfortunately, over the past couple of decades capital requirements and accounting standards have been watered down in the name of "supporting growth". In practice this means that marginal borrows continue to be funded and their claims on real resources (such as groceries) are not liquidated. 


Now let's examine what happens when loans go bad in the hyper-leveraged REPO  markets. The immediate effect was the 2008 collapse of the investment banks. Central banks and the taxpayers stepped into the breach and shored up these entities through massive lender-of-last-resort loans, recapitalization, and by simply purchasing distressed securities off their books for well above market values.

However, the fundamental problem remains. We are in a world where the financial system contain too many promises to pay, and not enough means to pay them. Bad loans are losing the moneyness all over the world, grinding down the capital on bank balance sheets everywhere. The world economy can not grow while it is weighed down by the the burden of servicing all the accumulated debt during the boom times. 

The repo markets are where the real action is. Banks will not lend against these deteriorating assets - whether they are mortgage loans, European debt, chinese grey market debt, etc. 

Left to itself, the world economy will experience a long deflation to clear out the excesses. However, the policy response of countries like the US and UK is INFLATION of the money supply. The obstruction to this policy are CREDITORS like Germany and China, who do not want to see the value of their loans inflated away. The battle of will between these opposing forces will continue and the outcome is a function of POLITICS.