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MARCH TO AUGUST : SYSTEMIC RISK CONCERNS
an April shareholder meeting that “the worst is behind us” —was that Bear would not
be the only failure.
THE FEDERAL RESERVE: “WHEN PEOPLE GOT SCARED”
The most pressing danger was the potential failure of the repo market—a market that
“grew very, very quickly with no single regulator having a purview of it,” former
Treasury Secretary Henry Paulson would tell the FCIC. Market participants believed
that the tri-party repo market was a relatively safe and durable source of collateral-
ized short-term financing. It was on precisely this understanding that Bear had
shifted approximately billion of its unsecured funding into repos in . But
now it was clear that repo funding could be just as vulnerable to runs as were other
forms of short-term financing.
The repo runs of , which had devastated hedge funds such as the two Bear
Stearns Asset Management funds and mortgage originators such as Countrywide,
had seized the attention of the financial community, and the run on Bear Stearns was
similarly eye-opening. Market participants and regulators now better appreciated
how the quality of repo collateral had shifted over time from Treasury notes and se-
curities issued by Fannie Mae and Freddie Mac to highly rated non-GSE mortgage–
backed securities and collateralized debt obligations (CDOs). At its peak before the
crisis, this riskier collateral accounted for as much as of the total posted. In
April , the Bankruptcy Abuse Prevention and Consumer Protection Act of
had dramatically expanded protections for repo lenders holding collateral, such as
mortgage-related securities, that was riskier than government or highly rated corpo-
rate debt. These protections gave lenders confidence that they had clear, immediate
rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Di-
mon, the CEO of JP Morgan, told the FCIC, “When people got scared, they wouldn’t
finance the nonstandard stuff at all.”
To the surprise of both borrowers and regulators, high-quality collateral was not
enough to ensure access to the repo market. Repo lenders cared just as much about
the financial health of the borrower as about the quality of the collateral. In fact, even
for the same collateral, repo lenders demanded different haircuts from different bor-
rowers. Despite the bankruptcy provisions in the act, lenders were reluctant to
risk the hassle of seizing collateral, even good collateral, from a bankrupt borrower.
Steven Meier of State Street testified to the FCIC: “I would say the counterparties are
a first line of defense, and we don’t want to go through that uncomfortable process of
having to liquidate collateral.” William Dudley of the New York Fed told the FCIC,
“At the first sign of trouble, these investors in tri-party repo tend to run rather than
take the collateral that they’ve lent against. . . . So high-quality collateral itself is not
sufficient when and if an institution gets in trouble.”
Moreover, if a borrower in the repo market defaults, money market funds—fre-
quent lenders in this market—may have to seize collateral that they cannot legally
own. For example, a money market fund cannot hold long-term securities, such as
