What was the exact role that the run in the sale and repurchase (“repo”) market played in the financial crisis of 2008-09 and what can we learn about today’s markets?
While more than a decade has passed since the financial crisis of 2008-2009, and a lot of research has been conducted on the reasons that led to the financial systems fragilities witnessed, there are still some dimensions of that massive crisis that have not been adequately investigated. Learning about them is very useful to avoid such fragilities from developing again in today’s financial markets.
Brittany Almquist Lewis addresses these questions in her recent paper “Creditor Rights, Collateral Reuse, and Credit Supply”. She focuses on a very important mechanism, the exact dynamics of which are still not completely understood: the repo market. Specifically, she asks whether the reuse of private-label mortgage collateral in repo markets, which should have contributed to increasing credit supply to mortgage companies and potentially excessive lending by such companies, created critical interlinkages of financial intermediaries, and led to increased riskiness of the assets underlying the collateral.
An important institutional feature that needs to be understood is that collateral received by a cash lender in a repo transaction can be rehypothecated, that is, the cash lender can reuse it in another, unrelated, transaction. Once the implications of this arrangement are fully understood, we can then trace its impact on the financial system. Specifically, this rehypothecation should have created a multiplier process for collateral, very similar to the money multiplier in the reserve banking system. One important insight of Brittany’s research is that increasing the reuse of private-label mortgage repo collateral led to an increase in, first, credit supply, and, second, through excessive lending ended up contributing to financial instability.
To establish this chain of events, Brittany uses a natural experiment provided by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 that strengthened creditor rights on repo. Specifically, BAPCPA granted preferred bankruptcy status to private-label mortgage backed collateral.
A chain of results are found that strongly point to higher (excessive) lending arising from the reuse of collateral and the subsequent impact on home prices, which were one of the triggers of the financial crisis. First, dealer-banks’ reuse of collateral increases following the introduction BAPCPA, i.e. after the strengthening of repo creditor rights. Second, the money multiplier effect of repo collateral reuse increases credit supply: dealers pass their increased credit supply on to the mortgage companies that they fund by increasing credit lines and loosening the covenants on the credit lines, incentivizing the mortgage companies to originate riskier mortgages. Third, and most importantly, there is causal evidence that during 2005 and 2006, the increased repo credit supply drove up home prices in counties exposed to mortgage originations funded via repo credit lines, and drove down home prices in these areas during 2008, consistent with a financial accelerator effect of repo funding.
The core result, which is the impact of the repo collateral reuse on home prices, is convincingly shown in the graph below which plots the behavior of home prices as a function of county-level market share of independent mortgage companies. Relative to less exposed counties, following BAPCPA counties more exposed to shock to repo markets significantly increased home prices during 2005-2006 and then were those that suffered the most during the 2007-2008 market stress period. The effect is economically significant.
This paper places under the spotlight the unintended consequence that legal or regulatory changes may have on other parts of the financial markets which could end up engendering fragilities in the entire system. In the case of Brittany’s paper, we learn that when overcollateralization requirements differ at each leg of the chain of reuse, increased repo reuse of collateral functions like a money multiplier, creating a positive credit supply shock.