Gary Gorton has written another excellent paper, available here. It explains one corner of the crisis very well and it is this kind of paper:
Table 1 shows the repo market haircuts for different collateral at different points in time. Of particular relevance are the first two columns of the table. The implications of this are very dramatic. Imagine a firm that is levered 30:1, by borrowing in the repo market. If the haircut doubles, or goes from zero to a positive amount, the required deleveraging is massive! Most investment banks were levered 30:1, equivalent to about a 3 percent haircut. If the haircut rises to 6 percent, at least half the assets will have to be sold.
Recommended for anyone taking a serious interest in contemporary financial markets and the crisis. On the question of stimulus, I recommend this discussion for anyone looking to understand why the correct multiplier is difficult to calculate.
first, the author refers to ‘tripartite’ repo when in fact it is called
‘triparty’ repo. second, he doesnt even mention money market triparty (ie
commercial paper) when the CP market has been at the very heart of the
crisis and at times even driving the process a la the Reserve Fund breaking
the buck.
I can’t reproduce the leveraging result quoted by Tyler above, which means I’m not really understanding it. Can somebody show me the math in the comments. I gotta think I’m missing something pretty simple.
Thanks,
Chris
It should be kept in mind that not only is the repo market very large,
if not not much publicized, but it has traditionally been where the Fed
did most of its open market operations, at least in the past. Part of
their rush to use all these new instruments may well partly reflect this
breakdown of its functioning. During late 2003, the market frequently
exhibited negative nominal interest rates, btw, probably the most sustained
outburst of those we have seen in a US financial market.
That’s precisely why the fattest economist alive couldn’t understand why there was such a massive hole in the capital markets, and had to resort to hand waving to explain it.
Tyler, Alex,
I’m curious about something. The anon blogger over at Free Exchange just concluded a post with this statement: “It’s important to remember that while this debate as occasionally turned juvenile and superficial, it has also been fruitful. And ultimately, we will emerge from this crisis with a better understanding of how economies function (and fail).”
Will we really? It seems just as plausible that if the economy recovers within a reasonable period of time, a lot of people will attribute it to the stimulus regardless of whether or not it was in fact the reason.
And if the economy doesn’t recover quickly, you could easily end up with one camp that says, “See? Keynes was full of it and fiscal stimuli don’t work” and another camp that says “See? I told you the stimulus should have been bigger”.
In neither case do we end up with a better understanding of how economies function. Thoughts?
I believe that Frank Shostak touched on this topic some time ago on mises.org. He pointed out the huge problems investment banks would be facing with even a relatively small haircut.
Does anyone know if a small securities firm can open a treasury or money market repo account with a bank? And if so what type of haircut or capital would be needed?
Comments on this entry are closed.