TODO: put references.
The short story of the crisis, according to several authors (citations to come) revolves around the existence of “Repurchase Agreement“, or repos. Repos are quite simple: imagine that, as a bank, you need some fresh cash. You realize that you could get a loan, but you could also give something else of value to your potential lender, which could help you getting more cash or a better interest rate, exactly like a pawnbroker. Imagine that you have this bunch of stocks which are not giving you high dividends but which are pretty stable in price. Then naturally, you will try to give them in exchange of cash to a lender, which is acting exactly like a pawnbroker.
In order to do this, you will can make a repo: the lender will buy you your stocks, in exchange of a promise that you will repurchase them as the end of the contract. Obviously, you will pay also some interests at the same time. Now, in the case in which you make default before the end of the contract, the lender can sell the stocks and get his or her money back.
Ok, so as a bank you can give whatever assets (stocks or else) in return for the cash? Well, obviously not. If you give very risky assets to the lender, he or she might not be able to sell them at an adequate price should you make default. This is why lenders are asking of a “haircut”, i.e. they will give you less money than what your assets are worse if they are too risky. The difference is the haircut, and it increases with the riskiness of the assets. Give good assets like US bonds, and you will get the same amount of cash than your bonds are worth. Give corporate bonds from company which is likely to make default before the end of the contract, and you will get almost no money out of your bonds, even if currently they are worth a lot.
So in summary, in a repo:
- the interest rate is an insurance against you making default
- the haircut in an insurance against the third party making default.
In the early 00’s, there was a huge demand from different institutions like pension funds for these repos. Indeed on one hand, these pension funds typically had loads of cash in treasury and needed a very secure way of getting some interests from it. On the other hand, other entities like investment banks needed the cash (as always…) and could pledge different assets for it. So they starting doing repos, where they were typically exchanging very secure assets like bonds against fresh cash. At some point, the demand was so big that these entities started pledging other types of assets, like derivative contract in the style of securitised assets.
What are securitized assets? Well, imagine that you have a company which lent money to 100 people in order to buy a house (mortgages). Imagine that you would like to pledge these mortgages in a repo. Well, this is not could, because you do not know who is going to default of their mortgage, so each mortgage is quite risky and you will have a big haircut. So instead, you say “I pledge the last 20 mortgages which are going to default”. It means that even if 80 percent of the people make default no their mortgage, well your pledge has always the same value. In other words, this new type of assets is very safe, and yields almost no haircut. Well, when everything goes well as least, but let’s not anticipate.
So investment were (are!) essentially doing this: buying 100 mortgages to the intial mortgage company, tranch them in three pieces, A (very safe), B (medium) and C (unsafe), and pledge these pieces against fresh cash.
So what went wrong? Well, several things. First at that time the mortgage companies were essentially giving money to anyone, even people without income (!). Why? Because the real estate market was booming, and the companies were taking your house if you failed to reimburse your loan. Since the prices were rises, the mortgages companies were making money anyway. But at some point, the prices dropped. And at this point, things went bad very quickly for these companies. Because many people were making default, the companies had to take and sell many house, which drove the prices down even further. People more even more indebted, because they purchased a house to a high price, but the house was not worth anything anymore.
Should that be a problem for securitized assets? Well no, that’s exactly what they were designed for, right? Except that, well the intermediaries were tranching the pool of mortgages, they were evaluating the risk for each mortgage… independently! This is ok when the market is stable, but when the prices go down, even normally very good mortgages profiles could turn out very bad.
And this is where people started to freak out and positive feed-back loops kicked in. When, as a pension fund, you suddenly realize that the assets you own might not be as good as you thought, you start asking for more haircut, to secure your position. If you the haircut increases, then the bank, with the same amount of assets, suddenly starts to have much less cash. If it has less cash, it is forced to deleverage (i.e. get rid of the most risky assets for instance) by selling assets, including stocks, which drives the prices down. At this point, the crisis begins to arrive in the production sector, where companies struggle with decreasing investments due to shortage of liquidity and stocks collapsing. So companies fire people or make default, so more people make default on their mortgages, further increasing the risk of assets used as collateral, further increasing the haircuts, etc.
Note that it is interesting how the repo/haircut story matches a bank run in the old days. The story is quite similar, and with worries about what people are actually holding in their respective banks. Suddenly, some people realize that their money are not secured and their start asking for more guaranties/taking their money out. Which leads the bank to sell its assets, usually triggering a market crash and so on.
Furthermore, the parallel is interesting on the policy side. If people talked about “Shadow Banking” very early, it was essentially in an attempt to claim that they did not know what was happening in this sector. Truth is, they knew, because the shadow banking is a direct consequence of the policies of the 80’s and 90’s. As a consequence, they let bank play with a huge amount of money without any restrictions. Note finally that very little has been down in this regard in the past years.