When Treasury Secretary Henry Paulson said in September 2008 that he needed nearly $1 trillion to fix the financial markets, I knew subprime mortgages alone could not have done that kind of damage. Didn’t banks pool those loans and sell slices of the pools to investors? Don’t investors make and lose billions of dollars on the financial markets every day? Why were their losses suddenly landing in the taxpayers’ laps? Something else had to be involved, something hidden, something I wasn’t aware of, something dangerous. Here it is.

The 2008 disaster began when many bankers, encouraged by politicians, regulators, shareholders, deregulation and easy profits, lowered their lending standards and made vast numbers of home loans to people who would not normally have qualified for a loan. Then the bankers packaged up those home loans and sold slices to investors worldwide, to get the money to make more home loans. This lending chain is called securitization.

Bankers kept making home loans and selling them as long as they could. But then waves of the new homeowners couldn’t make their monthly mortgage payments, and every link in the securitization chain suffered big losses, from homeowners through bankers to investors. In 2008 U.S. officials decided some of the Wall Street banks and their trading partners were so big that taxpayers had to bail them out, to prevent an even worse recession than we have.

All of this is true. But parts of it don’t add up. For example, investors regularly lose tons of money. In the dot.com and telecom busts, investors lost almost twice what they lost on mortgages. Why were mortgages so crippling?

Most important, why did all the financial markets seize up – including business loans, car loans, and money market funds – when the problem was in one corner of the mortgage market? Regulators said the crisis was “systemic.” What did that mean?

If this is confusing, it’s because the most important piece of the crisis story is missing. Here it is:

It turns out that one-fourth of the mortgages supposedly sold to investors were actually held by the bankers. Those bankers often used the mortgages as collateral to get overnight loans from each other and from other financial institutions.

This kind of borrowing has a name. It’s called repurchase (or “repo”) borrowing, because technically the borrower sells the collateral to the lender and promises to buy it back, to “repurchase” it, the next day – although usually the lender agrees to renew the loan for another day.

This was how bankers got much of the money to make home loans. Bankers got a repurchase loan, used the repo money to make or buy home loans, used the home loans as collateral to get more repurchase loans, used this new repo money to make or buy more home loans … and so on. The cycle was very profitable for bankers, but it depended on their going deeper and deeper in debt to their repo lenders.

Bankers also used this cycle to finance business loans, car loans, credit cards, student loans and much more. In the past decade, securitization and repos – which together are called securitized banking – came to provide half the credit in this country. This securitized lending eventually equaled traditional lending, which is done by banks using their depositors’ money. Big banks prefer securitized lending because it’s less regulated and more profitable.

Large banks also use repos to finance their Wall Street trading and other operations.

Every night about $7 trillion is borrowed on the U.S. and European repurchase markets, yet most Americans have never heard of it because the transactions occur privately among global financial institutions. In the U.S., 21 companies are thought to do about 90 percent of the borrowing.

Participants include the mega-banks, money market funds, hedge funds, mortgage giants Fannie Mae and Freddie Mac, the Federal Reserve, mutual funds, states, municipalities, large businesses, pension plans, mortgage lenders, insurance companies, university endowment funds, some community banks and other financial institutions.

These companies become intricately interconnected as both borrowers and lenders on the repurchase market.

Repo was a key reason that the financial crisis was “systemic.”

In 2007 and 2008, repo lenders started to worry about the quality of their collateral and the financial condition of the repo borrowers. They refused to renew their repo loans. Suddenly forced to repay, financial institutions like Countrywide, Bear Stears and Lehman Brothers hemorrhaged cash and plummeted toward insolvency.

When frightened repo lenders demanded their money back, it was just like 100 years ago when frightened depositors lined up outside their banks and demanded their deposits back.

In 1907 it was called a run on the bank. In 2007 it was called a run on repo.

All financial markets panicked. In the chaos, securitization fell 44 percent in one year. With the fall vanished $1 trillion a year in loans for cars, commercial real estate, credit cards, large and small businesses, many other consumer and business needs and, of course, for mortgages.

The repurchase market, then, was a key transmission mechanism, an amplifier, that carried the shock wave from a small part of the housing market through the canyons of Wall Street to all corners of the economy and to the American taxpayer.

The 2008 financial crisis was not caused by homeowners who borrowed too much money. It was caused by big financial institutions that borrowed too much money, much of it on the repurchase market.

Unfortunately, the repurchase market is not being fixed, and the main users of that market are bigger than ever. Congress has focused its fixes on mortgages and on derivatives. But that won’t stop the next run on repo if lenders panic over a different kind of collateral or hear a false rumor and panic for no reason at all.

Thanks for your interest.
Mary Fricker
Editor, RepoWatch
November, 2012

“The essence of shadow banking is to make loans, securitize them, sell the securities and insure them, and actively trade all the financial assets involved. In effect, traditional relationship banking is replaced by a collateralized market system with the repo market at its heart.”
– William R. White, Organisation for Economic Co-operation and Development, August 2012.

“What was different about this crisis was that the institutional structure was different. It wasn’t banks and depositors. It was broker-dealers and repo markets. It was money market funds and commercial paper ...”
– Federal Reserve Chairman Ben Bernanke, March 27, 2012.