COTW: The Panic of 2008 Revisited

Phoenix Capital Research: the dreaded expanding wedge formation

'Big Calculator' Idonwanna sez: DTX40 + JRBs = W/X

Readers of this space will often see US Person refer to the financial crisis lately passed as the "Panic of 2008", because it was exactly that. Say the words "financial panic" and people might think of depositors lining up outside desperately trying to get their money out of a bank that has closed its doors to business. Such scenes actually occurred in 1933 which led FDR to declare a nationwide bank holiday. This time around it was not banks and depositors that panicked, but players higher up the financial food chain: broker-dealers and repo markets. Repo is an abbreviation of repurchase agreement. Investment bankers and others sell securities for short term capital loans (typically a day to three months) which they can pay off at a higher price by repurchasing the collateralized securities. The difference between the spot price and the forward price is essentially the interest on the loan. They are recognized a single transaction in contrast to a sale and purchase for tax purposes. These deals have become essential to the operation of world-wide financial markets. Often dealers use repos to establish a long position in bonds without using their own capital to pay for the purchase; conversely they can take a short position in bonds by using a reverse repo (dealers buy securities).

What happened in 2008 was a meltdown of the repo markets. New York Fed Chairman William C. Dudley described the panic that gripped the market: "Higher margins on repo and increased collateral calls due to credit ratings downgrades reduced the quality of assets that could be financed in repo markets and elsewhere, prompting further asset sales. As wholesale investors started to exit, this set in motion a bad dynamic--a fire sale of assets that cut into earnings and capital." In less oblique terms, the actual value of assets being pledge came into doubt, so lenders began increasing the demands for collateral and higher resale prices. Unable to finance their suspect securities in the repo market, banks began hoarding liquidity fearing investors would run against them. Former Chair Ben Bernanke said, "What was different about this crisis was that the institutional structure was different. It wasn't banks and depositors [as in the thirties], it was broker-dealers and repo markets. It was money market funds and commercial paper."

Why did this happen? The short answer is, as the New York Fed tells us at length in their 2013 report, the banks and big investors in the financial world like their arbitrage this way. It may be risky business, but the shadow banking system helps them avoid taxes, avoid holding capital for collateral, avoid regulation, and make more money which always is the bottom line. The New York Fed: "Intermediaries create liquidity in the shadow banking system by levering up the collateral value of their assets. However the liquidity creation comes at the cost of financial fragility as fluctuations in uncertainty cause a flight to quality from shadow liabilities to safe assets." "Black-box banking" may risk the entire economy but why should banksters care when they can extort the federal government into giving them $13 trillion bailouts? All the ballyhooed financial reform that took place in the aftermath of the Panic of 2008 is supposed to prevent such financial terrorism, but do not bet your house on it. The problem with the $7 trillion-a-day repo market has not gone away since the 2008 Panic. The solution to the problem is of course, real market regulation not window dressing. If entities like hedge funds, money market funds, insurance companies, and pension funds want to act like commercial banks and lend money they should be regulated like commercial banks including meeting capital requirements. Even those "pinko" editors at Bloomberg think so.