All the Devils Are Here [150]
As the market got crazier, money market funds became more and more enamored of this paper; they, too, were competing for that extra little bit of yield. Although money market funds were serving the role of the old-fashioned bank—they were ultimately the real lender—they weren’t regulated the way banks were. Since they were holding highly rated securities—as SEC rules required them to do—no one in the government was concerned with the quality of the collateral.
But what would happen if the money market funds all started questioning the quality of the assets backing their paper at the same time? What if they all stopped buying it? Either the sponsoring bank would have to provide liquidity—damaging its own balance sheet—or the vehicles would all have to start dumping assets to raise cash. Neither scenario was pleasant to contemplate.
Money market funds were also a core enabler of the deepest, darkest, least noticed part of the market’s plumbing. This was the so-called repo market, which made it possible for firms to pledge assets in return for extremely short-term loans, often as short as overnight. Yale economist Gary Gorton—the game man who did risk modeling for AIG-FP—explains the repo market this way: Suppose Fidelity has $500 million in cash that it plans to use to eventually buy securities. It wants a safe place to earn interest on that cash while making sure the money will be available the instant it wants it back. Enter the repo market. Fidelity can deposit the $500 million with an investment bank—Bear Stearns, in Gorton’s example—and be sure the money is safe, because Bear provides collateral to back up the loan. The difference between the money Fidelity gives Bear and the value of its collateral is called the “haircut,” and before the crisis a 2 percent haircut—meaning Bear could get 98 cents in cash for every $1 in assets it pledged—was a normal number.
Secured lending, or lending against collateral, is almost always less risky than unsecured lending. On the Street, the repo market is called the last line of defense, because you can get money there when you can’t get it anywhere else.
And yet, there were dangers in the repo market, too. It is a murky market, but a huge one: according to a report by the Bank for International Settlements, by 2007 the U.S. investment banks funded roughly half of their assets using the repo market. For firms that depended on this market, there could be a timing mismatch, because banks could pledge a long-term illiquid asset in return for short-term funding. If the short-term funds went away, they still had the asset—which needed financing. Another danger was that repo transactions are exempt from the normal bankruptcy process. Lenders didn’t have to worry about their money getting tied up—they could simply grab their collateral at the first sign of weakness. And whichever lender grabbed first did best: no bankruptcy court judge was going to come along and decide what was and wasn’t fair.
As the bubble grew, Street firms began using riskier and riskier assets—including mortgage-backed securities—as repo collateral. They did it for the usual reason: the lender could get a bigger return by accepting mortgage-backed securities as collateral than it could by accepting Treasuries.
But once again, what would happen if the lenders began to question the true value of the collateral? The lender might demand a bigger haircut—meaning that the loan the bank would get would shrink, and it would have to rapidly sell assets, or face a shortage of funds. Or what if the lender didn’t want any collateral from a particular firm at all? Suddenly a routine repo transaction would be transformed into something far more ominous: a vote on whether an investment bank should survive.
Thanks to deposit insurance, the days were long gone when bank customers stood in line to pull their money out of a shaky bank, creating a run on the bank that usually