Repo is a repurchase agreement in which a bank buys a security and pays for it by selling it to an investor for a small period of time, with a promise to repurchase it back at a price. As Tooze writes, “The investment bank would buy $100 million in securities and repo them with a mutual fund or another investment bank, with the party repoing the paper paying a small interest charge to the investor it was repoing with. It also accepted a haircut. In exchange for $100 million in Treasurys, it did not receive full value, but only $98 million in cash. It would also repurchase them for $98 million. In the meantime, the haircut determined how much of its own money the investment bank would have to put into holding the securities, and thus the leverage in the deal. A 2 percent haircut meant that to fund the purchase of $100 million of securities and to receive the interest paid on those bonds, a bank would need $2 million of its own money. The rest it could get out of the repo transaction.”

This mechanism allowed for big balance sheets with much smaller capital, provided the repo could be continuously rolled over and the haircuts did not rise suddenly. Both these conditions reversed during the crisis. Trillions of dollars of collateral were posted in repo markets, with the private label MBS in bilateral repo market which was thrice the size of triparty repo market. When an investment bank suffered huge losses on its portfolio, the private label MBSs as an asset class lost confidence as collateral for rolling over repo – a general loss of confidence such that the banks found themselves shut out of funding. As Tooze puts it, “If any one of these investment banks was to lose access to the repo markets, at a stroke its business model would collapse, taking its entire balance sheet—not just its MBS business, but its derivatives book, currency and interest swaps—down with it.”

This was exactly what happened. In Tooze’s description: “When news of a new round of mortgage failures hit the markets in March 2008 and hedge funds began emptying their prime brokerage accounts, quite suddenly the haircuts Bear Stearns faced in the bilateral repo market steepened and access to trilateral repo funding was shut off. A bank that in early March had easily been able to raise $100 billion overnight in exchange for good collateral could no longer fund itself.” There was no price adjustment in the triparty repo market while funding terms were getting stiffer and stiffer in the bilateral repo market. This was the so-called ‘run on the repo’. Unlike the old-fashioned ‘bank run’ where depositors rush to get their cash out from their accounts, there were no queuing depositors to be seen but a withdrawal of liquidity from the repo market which precipitated the crisis.

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019

Eurodollars are dollars held outside the US regulatory jurisdiction. It has no connection with the ‘Euro’ currency. The post-World War II Bretton Woods system had capital controls to minimize currency instability and to manage the global shortage of dollars which served as a constraint on the private banks. As US became a large consumer market and imported goods, dollars outside the US grew significantly. With the implicit permission of UK authorities, the London banks sidestepped the fetters by accepting dollar deposits from the wealthy and lending in dollars. This was a source of dollar liquidity outside the ambit of Fed’s regulatory powers. As Tooze puts it:

“eurodollar accounts in London offered the basic framework for a largely unregulated global financial market. As a result, what we know today as American financial hegemony had a complex geography. It was no more reducible to Wall Street than the manufacture of iPhones can be reduced to Silicon Valley. Dollar hegemony was made through a network. It was by way of London that the dollar was made global.”

CRASHED: HOW A DECADE OF FINANCIAL CRISES CHANGED THE WORLD, ADAM TOOZE (2018)

As the old Bretton Woods collapsed and capital controls were lifted, these Eurodollar accounts were awash with dollars. In Tooze’s description: “Driven by the search for profit, powered by bank leverage, offshore dollars were from the start a disruptive force. They had scant regard for the official value of the dollar under Bretton Woods and it was the pressure this exercised that helped to make the gold peg increasingly untenable. When the final collapse of Bretton Woods coincided in 1973 with the surge in OPEC dollar revenue, the rush of offshore money through London’s eurodollar accounts became a flood.”

European banks held 20% of US subprime MBSs while two-third of the ABCPs issued by SIVs had European sponsors. These contracts were dollar denominated, both on the assets and liabilities side of the balance sheet which exploded. Eurodollar was their source of wholesale funding. The Chinese, Russian and Middle-eastern wealth funds looking for relatively safe and high-yielding assets invested heavily in the SIVs which offered complex short term dollar-denominated financial instruments like ABCP. Thus, eurodollar became an integral component in the market-based shadow banking system where it stood outside Fed’s regulatory ambit and in which the European authorities bet on the Fed bailing them out if the eurodollar funding froze.

In 2007, European banks had a dollar asset-liability mismatch of about $1 trillion, which the ECB couldn’t have dealt with, with its puny $200 billions, in the event of a collapse. The central nature of eurodollar in the system is further reinforced by ECB’s “audacious assumption” that, as Tooze notes, “collaboration would be forthcoming and in an emergency the Fed would provide Europe, and London in particular, with the dollars it needed. Given the scale of the offshore dollar business there could be no other answer.”

References:

1. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
2. Kapadia, A. (2019). Capitalism: Theories, Histories and Varieties, HS 449 (Class Slides). IIT Bombay, delivered Jan – Apr 2019