Academic journal article Business Economics

E-Coli, Repo Madness, and the Financial Crisis

Academic journal article Business Economics

E-Coli, Repo Madness, and the Financial Crisis

Article excerpt

All bond prices plummeted (spreads rose) during the financial crisis, not just the prices of subprime-related bonds. These price declines were because of a banking panic in which institutional investors and firms refused to renew sale and repurchase agreements (repos)--short-term, collateralized, agreements that the U.S. Federal Reserve rightly used to count as money. Collateral for repos was, to a large extent, securitized bonds. Firms were forced to sell assets as a result of the banking panic, reducing all bond prices and creating losses. There is nothing mysterious or irrational about the panic. There were genuine fears about the locations of subprime risk concentrations among counterparties. This banking system (the "shadow" or "parallel" banking system)--repos based on securitization--is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit will not be created.

Business Economics (2010) 45, 164-173.

Keywords: repo, financial crisis, panic, securitization, collateral

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  Unfortunately the subject [of the Panic of 1837] has been connected
  with the party politics of the day. Nothing can be more unfavorable
  to the development of truth, on questions in political economy, than
  such a connection. A good deal which is false, with some admixture of
  truth, has been put forward by political partisans on either side. As
  it is the wish of the writer that the subject should be discussed on
  its own merits and free from such contaminating connection, he has
  avoided as much as possible all reference to the political parties of
  the day. (Appleton [1857], May 1841)
  The current explanations [of the Panic of 1907] can be divided into
  two categories. Of these the first includes what might be called the
  superficial theories. Thus it is commonly stated that the outbreak of
  a crisis is due to a lack of confidence--as if the lack of confidence
  was not itself the very thing which needs to be explained. Of still
  slighter value is the attempt to associate a crisis with some
  particular governmental policy, or with some action of a country's
  executive. Such puerile interpretations have commonly been confined
  to countries like the United States where the political passions of a
  democracy had the fullest sway. ... Opposed to these popular, but
  wholly unfounded, interpretations is the second class of
  explanations, which seek to burrow beneath the surface and to
  discover the more ... fundamental causes of the periodicity of
  crises. (Seligman [1908] p. xi)
  The subject [of the Panic of 1907] is technical. Opinions formed
  without a grasp of the fundamental principles and conditions are
  without value. The verdict of the uninformed majority gives no
  promise of being correct. ... If to secure proper banking legislation
  now it is necessary for a ... campaign of public education, it is
  time it were begun. (Vanderlip, 1908, p. 18)
  Don't bother me with facts, son. I've already made up my
  mind.--Foghorn Leghorn

Yes, we have been through this before, tragically, many times.

U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we have repeated. A basic point of this note is that there is a fundamental, structural, feature of banking, which--if not guarded against--leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. We need this type of bank product; but, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem, this time with a form of money called sale and repurchase agreements ("repos"). …

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