Ten years after the collapse of Lehman Brothers Holdings Inc. showed just how crucial short-term funding markets are to the financial system, no one is sounding the all-clear.
There’s no doubt that the Federal Reserve has slashed risk in the repurchase-agreement industry by prodding participants and working with global regulators to strengthen the banking sector. The events of 2008 showed why the efforts were needed: Panic in repos, which grease the wheels of debt trading and are a key tool for overnight financing, helped speed up the demise of Lehman and Bear Stearns Cos. in the span of six months.
The threat of cascading failures has now diminished after clearing banks stopped extending intraday credit to repo dealers, which at the height of the crisis left them exposed to as much as $1 trillion worth of funding. The market is also more transparent and smaller in scale.
Yet a key systemic risk still worries Fed and industry observers: The potential that a party may abruptly dump repo collateral in a so-called fire sale should another large firm go under. And there are new wrinkles to worry about -- the regulatory burdens on banks have reduced activity and left only one firm in the business of clearing deals.
“There have been a lot of things done that have added to the industry’s safety and soundness,” said Murray Pozmanter, head of clearing agency services at the Depository Trust & Clearing Corp., which settles the bulk of debt trading. “But there’s definitely still a lot to do and I’d say we are mid-journey.”
Repos’ Role
While most people are aware that the financial crisis stemmed from unbridled subprime-mortgage lending and the packaging of those loans into securities, fewer may recall the role played by secured funding -- meaning repos. When lenders perceived that Lehman might not repay repo loans or be able to post adequate collateral, they required more and higher-quality assets from the firm, crimping its ability to fund itself.
The landscape of the repo world has been transformed since the crisis. The sheer amount of collateral being financed in tri-party repo -- where a third party settles the deals and safeguards the debt -- has shrunk to $1.9 trillion from a record $2.8 trillion in 2008.
The contraction came as new global rules forced banks to hold more capital on their balance sheets and cut leverage, leaving them less room for repo transactions, and making the business more costly and less attractive.
Fire-Sale Threat