Financial instruments are like used cars in that the incentive to pass off inferior products is strong. Buyer lack of information represents a market failure with fraught consequence. The last financial collapse, and the one coming, are fruit from the same lemon tree.
During the week of September 16, the overnight repo market, which was the epicenter of the financial crisis 12 years ago, ran short of liquidity. Repo is a portmanteau of “repurchase agreement.” A repurchase agreement is a transaction in which one party simultaneously sells a security and agrees to repurchase the security at a fixed price on a specific future date. The security is exchanged for cash, plus interest to be paid when the transaction is unwound.
Repos are used to source both cash and securities. Because repos are secured, they are considered relatively low risk. Of course, trust is involved between parties in any repo, as the quality of the security is not known to the buyer.
In 1970 American economist George Akerlof penned a famed article on “the market for lemons,” in which he identified the failure of the capitalist market mechanism when there is asymmetric information between buyer and seller – typically when a prospective buyer does not know the quality of the good he is considering (but the seller likely does). In this instance, the buyer may hope for a (sweet) peach but wind up with a (sour) lemon.
Capitalism is a confidence game, and confidence goes wobbly with uncertainty. Trust is the foundation of any relationship or transaction; the very thing which should be in short supply in an economic system where dishonesty can pay handsomely. But people are generally not adept at catching lies, and most tend to be naturally trusting (and gullible, as the world’s religions amply illustrate). That said, savvy capitalists and consumers get seasoned in the fine art of fleecing and avoiding being fleeced. Hence, trust becomes a shaky commodity under shady circumstances, and the market system is perpetually in the shade.
A study of used car prices in Denmark showed the market failure of the lemon mentality, which applies to repo securities during times of financial stress as surely as autos on an everyday basis.
Brand-new cars lose a great deal of their value the moment they are bought. The Denmark study showed an 18% “lemon penalty” in the 1st year of car ownership, and 8% the 2nd year. The lemon effect wears off over time. For cars owned at least 3 years, the penalty is 2–5%, and vanishes by the 9th year of ownership.
The reason for the lemon penalty for cars is that people who buy a faulty car would like to get rid of it. The same applies to lemony financial securities.
In financial markets, good times floats all boats. As the inevitable cycle of confidence grinds down, financial trading becomes a game of musical chairs. Bankers and investors grow more skeptical of the instruments being bandied, as the risks of default creep up. That the overnight repo market would stall shows impressive fear among institutional lenders.
The 2008 financial crises was the culmination of a debt-fueled boom in housing. Borrower default saddled lenders with losses in a widening gyre of insolvency.
The potential pinch now is corporate debt. Low interest rates spurred companies to take their borrowing for stock buybacks and risky investments to an untoward level if the economy at large were to falter.
Banks fund themselves in the short-term via demand deposits and through money markets, such as that for repos. By contrast, many bank assets are illiquid and long-term, such as loans to firms and homebuyers. This mismatch leaves banks vulnerable.
During the Great Depression, many banks failed when a multitude of spooked depositors demanded their cash. Though government-provided deposit insurance now protects against this hazard, it does not extend to money markets. In 2008, then, nervousness about the health of banks and their collateral triggered a flight from those markets, leaving healthy and unhealthy banks alike unable to roll over their short-term loans and at risk of imminent collapse.
These woes were amplified by the interconnectedness of the global financial system. Cross-border capital flows soared in the runup to the crisis, from 5% of global GDP in 1990 to 20% in 2007, spreading financial excess and outrunning regulators’ oversight capacity. Driven by avarice, money naturally gravitates to the highest return. Money from around the world poured into America’s mortgage market. The resulting pain was global. The Federal Reserve’s 1st crisis intervention, in August 2007, was a response to money-market turmoil prompted by difficulties over funds run by a French bank, bnp Paribas.
Chastened by the near-death experience a decade ago, governments introduced measures intended to instill caution. Unsurprisingly, the fetters were then loosened to keep the recovery going, and were otherwise inadequate to preclude a recurrance.
Risky borrowing again became a norm. The American market for syndicated business loans boomed as loan standards fell, to over $1 trillion in 2018. Many such loans are packaged into debt securities, much as dodgy mortgages were before the 2008 crisis. Regulators have declined to intervene.
The persistence of low interest rates inspired risk taking by institutions desperate for fat financial returns. Investment funds, pension managers, and insurance companies have been eager buyers of securitized bank loans. Some now have an ominously bank-like maturity mismatch. Insurers in some countries, including Japan and Korea, have hoovered up hundreds of billions of dollars of foreign bonds, hedging their exchange-rate risk on a rolling, short-term basis. If, in a crisis, these funds cannot renew their hedges, losses will overwhelm them. The vulnerabilities of supposedly staid firms are an underappreciated source of risk for big banks.
The obscured dangers are there because finance remains globalized. Money sloshes around the world, much of it outside the purview of regulators. Some unanticipated turmoil in one niche of the world financial system could spiral into global catastrophe.
The recent disarray in the repo markets illustrate the threat posed by this opacity. Some poorly understood force nudged mistrust from fear of lemons to a level which froze the American overnight repo market.
No obvious disaster looms. But the same could have been said of most financial crises before they happened.
The Great Depression was convincing evidence that financial capitalism was inherently dangerous. In the 40 years that followed, crises were infrequent; a testament to draconian financial regulation and capital controls. Since the deregulation which began in the late 1970s, financial crises have been depressingly periodic. The next one is likely to come in a panic, following the time-worn pattern.
“Repo-market ructions were a reminder of the financial crisis,” The Economist (26 September 2019).
“Can you buy a good second-hand car?,” ,” The Economist (26 September 2019).
Jack McCabe & Alison Touhey, “Bank liquidity and the repo market,” ABA Banking Journal (24 September 2019).
Liz Capo McCormick et al, “Repo market’s liquidity crisis has been a decade in the making,” Bloomberg (24 September 2019).