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March 4, 2013 6:51 pm
In September 2008 Matt King, a strategist at Citigroup, took note of a remote corner of financial markets. While investors in big banks had been fretting about losses on repackaged subprime losses, there was a bigger problem looming.
“The major question facing all financials going forward is not one of writedowns, but one of funding and leverage,” Mr King wrote. “The very same features which are designed to make ‘repo’ safe for cash lenders do tend to create risks for those who depend on it for their borrowing.”
Just 10 days after Mr King’s note was published, Lehman Brothers declared bankruptcy after finding itself unable to roll over the vast amounts of funding it had sourced from the repurchase or “repo” market.
This market is one of the biggest in the financial world. It helps fund trillions of dollars of securities and financial transactions every day. Collateral transformation will fund the conversion of those assets, too.
In a typical repo transaction, a bank pledges an asset, such as a US Treasury bond, in return for a short-term loan. The asset is meant to protect the lender in the event of a default.
Because repo is secured by collateral, it tends to be regarded as safer than unsecured financing. But there is a catch. The repo market has a tendency to pull back during times of market stress. When market participants grow wary of the assets being used as collateral in repo transactions, they may ask for additional security or simply withdraw.
Such pullbacks or withdrawals in the repo market have played a role in almost every significant bank failure in recent years – including Lehman Brothers and Bear Stearns.
The worry is that because collateral transformation is achieved through the repo market, it could also be susceptible to sharp pullbacks.
“During times of stress the haircuts on repo transactions can get really big,” says Craig Pirrong at the University of Houston.
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