Repo Credit Lesson from Paulson Auditorium

Chidem Kurdas

A broker does a repurchase transaction with a hedge fund. Mortgage-backed securities are the collateral. The fund get short-term financing; the broker holds the securities. This market broke down in 2008 and never recovered to pre-crisis levels. What happened?

That’s the question in a study by Gary Gorton and Andrew Metrick of Yale University and the National Bureau of Economic Research, presented this month at New York University’s Stern School of Business. The conference was held at an auditorium named after hedge fund manager John Paulson, an alumnus who’s been generous to the school. I’ve wrote previously about another talk, by credit specialist Edward Altman.

Messrs. Gorton and Metrick track the crisis from subprime-related assets into markets that had no connection to housing. Concerns about  the liquidity of the collateral led to increases in repo “haircuts”—the amount of collateral required for any given transaction. Toward the end of 2008 haircuts on structured debt went up to 45% from almost nothing.

Kent Daniel of Columbia Business School pointed out that if the hedge fund were to default, the broker would have the collateral. The problem is that few people understand mortgage-linked and other complex securities. Repo collateral was information-insensitive, says Professor Gorton.

A group of hedge funds specialized in these instruments but in the crisis they stopped buying. So the holder of the collateral had to sell while those who had experience with the asset withdrew from the market. The buyers left were not sure which securities contained bad  subprime mortgages.   Prices plunged while haircuts rose. The run on repos resembled old-fashioned bank runs.

What does it mean for the future of repo financing? That information about the nature of the collateral is important. If only a small number of buyers have the ability to evaluate an asset, then in a financial downturn it becomes just about useless as collateral.

Thus the availability of information to other people – not just to you – is an indicator of liquidity in a pinch and should be factored into the risk of the asset. That’s a lesson for banks, brokers and hedge funds.

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