More on Repos

After my last post on this, I went to look up some more facts on the repo market. This issue concerns not only the importance of "safe assets," but also the role of the repo market failure in precipitating further financial market instability. I ran into a paper by Krishnamurthy, Nagel, and Orlov that provides new data and presents a revisionist take on the role of repo in the shadow banking system. Here are some principal quotes:

The table also details the amount of these securities financed by repo. Total repo of non-Agency MBS/ABS is $171bn. Even if we include the repo extended against corporate bonds, the repo total is only $386bn. This is a small fraction of the out- standing assets of shadow banks. This observation underscores a principal finding of this study: repo was of far less importance in funding the shadow-banking sector than is commonly assumed.
If repo was not the principal source of funding, what was? The table details the direct holdings of these securities by MMFs and security lenders. The direct holdings are substantial, totaling $745bn. It is likely that such holdings are high grade and short maturity tranches of securitization deals...

First, while in their data average haircuts are frequently zero in 2007 for corporate debt and securitized products, the repos undertaken by MMF in our data always have average haircuts of at least 2%, even for Treasuries and Agency debt. Second, although our value-weighted averages (which is the most relevant measure of aggregate funding conditions) are difficult to compare with the equal-weighted averages in finer categories reported in Gorton and Metrick (2011b), an informal comparison suggests that haircuts in tri-party repos of MMF increased much less than the haircuts in their bilateral repo data (Gorton and Metrick report average haircuts in excess of 50% for several categories of corporate debt and securitized products).

Taken together with our findings of the relatively small amounts of MMF repos against private-label MBS and ABS collateral, these observations suggest that the “run on repo” may have had a more modest effect on aggregate funding conditions for the shadow banking system than what one may guess from the enormous increase in haircuts for securitized products in the bilateral repo market as reported by Gorton and Metrick (2011b)...

 This finding does not support the emphasis that Gorton and Metrick (2010, 2011b, 2011a) and Adrian and Shin (2010) have placed on the repo market in explaining the collapse of the shadow banking system. Instead, the short-term funding of securitized assets through ABCP and direct investments by money market investors are an order of magnitude larger then repo funding, and the contraction in ABCP is an order of magnitude larger than the run on repo. Troubles in funding securitized assets with repo may have been a major factor in the problems of some dealer banks that were most heavily exposed to these assets, but for the shadow banking system as a whole, the role of the repo market appears small.

These results are in strong contrast to Gary Gorton's work, which has focused on the bilateral repo market. His research suggested that the financial crisis could be understood as a bank run similar to past financial crises, as in the 1930s. However, in this case, the bank run simply came instead to the shadow banking system in the form of the repo market closing up. The implication is that much of the fallout in the last several years can be understood using the same framework for why maturity mismatch induces normal banks to face runs.

The results from Krishnamurthy and company are in some tension with this interpretation. Repo by itself seems to have constituted a small share of financing in the shadow banking system. Correspondingly, the "run" on repo had little impact on aggregate bank financing systems (though painful for certain individual banks). The run was concentrated on repos collateralized by private label AAA securities, not on repos in general. Even risky banks were able to obtain repo financing by collateralizing with different securities.

Meanwhile, repo haircuts for some assets mirror their levels during the crisis. This seems inconsistent with the idea that the crisis involved some extraordinary and temporary run, as opposed to a general shift in the attitude towards the risk of certain assets.

To be sure, the results are specific to repo supplied by dealers and money-market-mutual funds. It seems likely that their financing supply remained more inelastic throughout the crisis compared to financing between banks, which decreased dramatically in response to a credit crunch environment.

It's interesting to compare this narrative with Ivashina and Scharfstein, who argue that new bank lending had begun to decline in 2007Q3, well before the turmoil in repo/shadow banks became more pronounced. A GNI approach to the economy shows stagnation in this period as well, while mortgage defaults were starting to kick in.

One story consistent with all of this would emphasize the role of deteriorating productivity and credit conditions throughout the crisis, combined with a shadow-bank driven monetary crunch in 2008. Stagnating income for a substantial period of time induced higher levels of household borrowing; defaults on which triggered bank retrenching. In turn, this induced short-term financing effects that were important, but largely limited to inter-bank financing. The bank repo effect, however, comes with a money multiplier that continued to further amplify the crisis.