Financial Crisis Watch: Repo Market Madness

We should be very concerned about the recent disruptions in the financial markets, and the strong similarities to the last financial crisis. The next crisis might be just around the corner.

There has been a lot of discussion of the recent unusual activity in the repo markets, and the Federal Reserve's ongoing response to stabilize it. See this Fortune piece for a quick rundown. In short, in the third week of September, repo (short for repurchase agreement) rates spiked from the target of around 2% to nearly 10%, causing the Federal Reserve to intervene to provide billions in liquidity on a daily basis (making cash available for overnight lending backed by Treasury and other securities). Banks and other financial institutions rely on these repurchase agreements, in which securities serve as collateral for short term loans, to help fund day-to-day operations. Though it is usually hidden from view, the repo market serves as a very important part of our financial machinery (often referred to as financial 'plumbing'), and its failure to function properly can contribute to larger problems in the financial system. For more detailed discussion of the repo market, and similarities to the last financial crisis, see:

For an insider's discussion of current conditions in the markets with historical reference to the failure of Northern Bank in the UK in the lead-up to the last crisis, and to the failure of Austrian bank Creditanstalt in 1931, see:

The Ghost Of Failed Banks Returns (SeekingAlpha)

 

A number of explanations have been floated for the recent repo market ruckus, including:

  1. It's the end of the quarter, and financial institutions need increased liquidity for taxes ad other one-time payments
  2. The Saudi Aramco attacks caused some investors to seek the safety of cash (same link as #1)
  3. The market is choking on US treasuries
  4. Deficit spending is finally catching up to us (another way of looking at #3)
  5. Deutsche Bank needed liquidity replacements after the sale of its prime brokerage to BNP
  6. The gyrations reflect an 'enormous margin call; which signals the end of global credit creation
  7. A perfect storm of conditions which combines several of the above-listed reasons

The above list is by no means comprehensive. The proposed explanations run the gamut from the narrowly technical, small-picture view to the structural, big-picture one. The very profusion of explanations should make us uneasy, because it suggests that the financial system has become too complex to manage, and even those experts most familiar with its inner workings don't completely understand it.

To the extent that there is any consensus about what is going on, it seems to be that the unexpected hebavior in the repo markets reflects a combination of factors. But there is still significant disagreement about the interpretation of these recent events. The "perfect storm" theory has (at least) two competing interpretations. The first on attempts to minimize the significance of recent events, attributing them to a very uncommon confluence of "technical factors" that is not likely to be repeated (this is the explanation the Fed seemed to embrace initially, when it hoped that a few days worth of liquidity interventions would be enough to get the markets back to normal). In this view, "Volatility in the repo market has been concerning, but this liquidity shortage doesn’t look like systemic weakness to us. Last week’s stress appears to be temporary, and the repo market will likely calm down through quarter-end with the Fed’s help."

The problem with this interpretation is that the course of events has already made it clear that the initial view was inadequate, and that more central bank intervention will be required (at least through the end of the year). This raises the possibility that such intervention is a new normal, that ongoing Federal Reserve action will be necessary to maintain stability in the financial markets, and that permanent measures such as a standing repo facility might be necessary. It's hard to argue that there's no systemic weakness when financial markets only continue to function normally with the help of massive intervention (tens of billions of dollars a day) for an extended period of time (weeks already, turning to months, and perhaps even longer).

There is still disagreement about what exactly happened with the repo market in the last crisis (was that turmoil a cause or a symptom?), and it took time to understand how the convergence of many different factors had played out. At the time, few observers understood the full significance of what was happening, and that repo market upheaval was a harbinger of much larger breakdown just around the corner. It is very likely that years from now, we will still be discussing what the recent events in the repo market mean in the bigger financial and economic picture. I think we would do well not to overlook the significance of such events this time around.

Finally, I think it is very important not to get bogged down in the technical details when having this discussion. Doing so cedes ground to those 'experts' who had devised a too-clever-by-half financial system (you know it's bad when even IMF economists think that financial system is overdeveloped) that benefits a few at the expense of the rest of us. The discussion we need to have is of the strong possibility that the financial system is parasitic, a mechanism for looting the real, productive economy. When the financial system generates profits that are wildly unequal in distribution even when it is functioning "properly", and requires astronomically large diversions of capital from the larger economy when it is not, then it is past time to start talking about radical alternatives that actually meet human needs and protect human values. This is not merely an academic question, but rather is of crucial importance to the future of civilized existence. We should not forget that in the past financial crises have led to political chaos that set the world on fire. And through our complacency, it could happen again. We may not be far off.


*Follow-up*: This topic (the repo market) was the subject of a particularly bad attempt at an explanation on NPR's Marketplace today. The piece uses not one, but four separate analogies (bowling shoes, arcade change machines, the power grid, and plumbing) to 'explain' the repo market (each 'expert' they asked had their own analogy). Then, after all of that hand-waving, the bottom line explanation is a complete non-explanation. Andrew Metrick, professor of finance at Yale, glibly tells us that, unlike 2008, “there’s no concern about credit risk going on here. It’s really more about the plumbing of the system.” And... that's it. The piece wraps with, "The bottom line? What’s happening in the repo market right now is really just a plumbing problem," and Beth Hammack of Goldman Sachs says, "The Fed came in very quickly and they patched that leak. It’s going to hold for some period of time, and they’re looking at ways that they can fix it on a more permanent basis."

This is a comically bad discussion of the repo market, not least because it treats listeners like we're idiots. I think most adults are perfectly capable of understanding that the repo markets are where banks go to fund their day-to-day operations by putting up securities as collateral for short-term cash loans. Do we really need four separate analogies to understand that? Notice that none of these analogies really gets to the underlying causes of the unexpected behavior. The power grid analogy comes closest, by framing the issue in terms of supply/demand mismatch. But this is still only a very superficial explanation - why is there such a marked mismatch if there is no underlying structural imbalance or weakness in the financial system? Andrew Metrick seems to think, like a lot of other economists, that if he attaches a label to something then that means he understands it and is in control of it. But this condescending, throw-away 'explanation' - this is just a plumbing problem, don't worry about it - actually reinforces that we should be really worried about this. If Metrick or any of these other people had good, sound explanations for the repo market phenomenon that went back to underlying causes, rather than superficial reductions, then they would tell us. But informed observers can't agree on exactly what combination of factors is causing this repo market madness, so even the most authoritative experts are reduced to rhetorical fiddle-faddle to maintain some semblance of reassurance.

Remember that economists and financial experts acted like they were on top of things before the last financial crisis, and almost universally failed to foresee the magnitude of the meltdown. They should not get another free pass on this one. It's pretty clear that quantity of explanations is being employed to make up for a shortfall in quality here. But even if we take the plumbing analogy at face value, how is this supposed to be reassuring in any way? You're telling me that there's something wrong with the plumbing (a leak), that we don't really know the cause of it, and it's been fixed temporarily, but apparently a more permanent fix is needed. We may not all be plumbers, but everyone knows that when something goes wrong with the plumbing, you can be in a giant sh*tty mess that's expensive and difficult to clean up. Here the plumbing analogy is being used in an attempt to reassure the non-expert listener that there's nothing to worry about - but if you follow it through, it suggest that there's actually a lot to worry about (some underlying cause of leaks that hasn't been diagnosed, requiring a permanent fix that hasn't been agreed upon yet, possibly leading to more leaks if the current temporary solutions don't hold up). Forgive me for not being reassured.


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