I’m still reading and enjoying the Financial Crisis Inquiry Commission report. I think it’s one of the best introductions to what has happened; I’m learning new stuff throughout it. Though one problem I’m having is that while the breadth of the topics is all inclusive, it is difficult to discriminate between how much causation to put on many of the issues, especially as we get further along in the crisis.
Example: One thing I’m thinking about these days is the role of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 in the crisis. I think the 2005 Bankruptcy Reform is pretty much been proven to be a disaster bill, and if we learned that it helped spark the shadow banking panic that would be even better. During the financial reform debates I did an interview with Stephen Lubben about it. I’ve been meaning to learn more since.
The FCIC document brings up the derivative amendments that were snuck into the bankruptcy reforms and their role in the crisis:
The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight. Subsequently, other laws enabled the expansion of the market. For example, under a 2005 amendment to the bankruptcy laws, derivatives counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy. (p. 48)
Regulatory changes—in this case, changes in the bankruptcy laws—also boosted growth in the repo market by transforming the types of repo collateral. Prior to 2005, repo lenders had clear and immediate rights to their collateral following the borrower’s bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that provision to include many other assets, including mortgage loans, mortgage-backed securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-2007, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source (see figure 7.1). Once the crisis hit, these “illiquid, hard-to-value securities made up a greater share of the tri-party repo market than most people would have wanted,” Darryll Hendricks, a UBS executive and chair of a New York Fed task force examining the repo market after the crisis, told the Commission. (p. 114)
The repo runs of 2007, 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 securities 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 30% of the total posted. In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 had dramatically expanded protections for repo lenders holding collateral, such as mortgage-related securities, that was riskier than government or highly rated corporate debt. These protections gave lenders confidence that they had clear, immediate rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Dimon, 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 borrowers. Despite the bankruptcy provisions in the 2005 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.” (p. 293)
But it’s sort of flat. I can’t tell if it is a major cause of the panic, a minor cause, a clarification of standard practices, industry-wide, etc. There’s little original data or research, which is probably expected given the exercise, but it’s tough to distinguish the interesting small things versus the interesting important things. For a general reader that won’t matter too much, but for people trying to figure out where to go next it is very important. This is true broadly of the topics they bring up. The section on the shorts and the synthetics (p. 190-195) is a great description I’ll just encourage you to read, but at the end it’s tough to tell how much weight should be placed on this – if it is a major cause, or an interesting sideshow.
They are doing large data dumps on what they researched and founded to go with the report. I’m hoping that this will allow researchers, academics and interested parties to dig in and fill in the missing shades and depth in the causes of the crisis. We’ll see how that works out in practice.