[MUSIC] We spoke in the previous lesson about sales and repurchase agreements. Shorthand, repo. Now let's talk a little more detail about how repo works. It is effectively a new type of banking. Another way for a bank to take a deposit from some type of investor or depositor and promise to pay it back. So effectively, the deposit is a short term, just like a deposit would be in a bank. It receives interest. And the difference is instead of insurance, it's backed by collateral. The depositor takes legal ownership of that collateral. So for example, if a large money-market mutual fund wants to deposit $100 million with an investment bank, they'll hand that $100 million over to the investment bank. And the investment bank will respond by giving them $100 million or more of bonds, which the money-market mutual fund then takes legal ownership of in case they don't get paid back. Now what's important about this legal ownership is that, starting in 2005, a broad class of bonds were carved out of the Bankruptcy Code. And there is an allowance of unilateral termination by the non-defaulting party. Now let me talk a little bit about what that means and why it's important. Once again, if I represent the money market mutual fund and I've handed $100 million of cash over to an investment bank, and the investment bank hands me collateral in response to that. And then tomorrow when I say, I would like my money back, because we had signed a one-day repo agreement, if the bank then says, I can't pay you back, sorry I don't have the cash. I do not have to say, well, I'm taking you into bankruptcy. I'm gonna go to the court and say, you haven't paid me back and then we have to go through a very long bankruptcy process for me to be able to get my money back. That's the way it would work for an ordinary business transaction. Instead, what we have is that repo has been given a special exemption, a safe harbor out of the Bankruptcy Code. So what I can do is say, you've defaulted, I'm just going to keep your collateral and I'm just gonna turn around and sell it in the market and get all of my money back. This turns out to be an extremely simple and very low transactions cost way to promise repayment. And part of the reason that in 2005, the Bankruptcy Code was revised to allow a broader class of securities to get carved out in this way is that the market participants were clamoring for it. They were saying, what you used to let us just do in this world was only government bonds, isn't enough. We've run out of that kind of collateral. We need more types of collateral that we can use so people can promise to give us our money back. Now there's two types of repo that you will hear about, and the distinction is not important for our purposes in this course. But for some of the descriptions of specific instances, you'll see these terms bandied about. And the two types of repo are bilateral, when two different parties are directly contracting with each other, and tri-party, where there's some bank that stands in the middle. Bilateral repo is the example that I've been using all along so far, which is money market mutual fund. For example, handing money over to an investment bank, who hands them collateral back. In practice, when money market mutual funds are involved, they usually wanna have a bank standing in the middle. So the money market mutual fund, for example, would hand their money to JP Morgan. JP Morgan would hand the money over to the investment bank. The investment bank would hand the collateral to JP Morgan. And everything would sit in custody at JP Morgan. Now it turns out that tri-party repo has its own set of risks associated with it. As you might imagine, JP Morgan in that example is now on the hook, if something were to happen to their counterparty, particularly because of the complicated way that transactions get put together during the day. In fact, that will play a role in the bankruptcy of Lehman, which we'll talk about in a later lesson of this module. Now, another term of art that you will hear with regards to repo is rehypothecation, which is just a fancy way of saying reusing. So you can reuse the collateral. The money market mutual fund that hands over $100 million to a bank and then the bank hands them a bond worth $100 million or more. The money market mutual fund has legal title to that bond. So they're actually allowed to take that bond themselves and sell it or lend it out somewhere else. They're not required to hold it on their balance sheet the entire time. In this respect, the bonds that are used as collateral in repo end up playing a very similar role to money. They could be transferred from pocket to pocket. And in the end, when you have to unwind the transaction, you're not always in most instances required to give exactly the bonds back that you borrowed. But rather, some bond that has the same value or is similar to it on other characteristics. This makes repo a type of money. So effectively, it can transfer through and multiply the same way that money can through the economy. And in fact that's how it was used often in the years leading up to the financial crisis. Now I've mentioned that collateral will often exceed the amount of money that was borrowed. You will over-collateralize the loan. And that makes sense. If I'm gonna give you $100 million of cash, I don't want a bond just worth $100 million. That doesn't really promise that you'll pay me back tomorrow because the bond might end up losing a little bit of its value between today and tomorrow. And if I'm making the loan for a full month, the bond might lose its value for sure over that full month. So often you will see collateral value exceeding the amount of cash that has been deposited. And this is called a haircut. Now unfortunately, the word haircut, in addition to its regular everyday meaning of cutting your hair, has a variety of meanings in the financial world. The meaning that it has within repo, is that there'll be some small percentage difference, usually a small percentage difference, between the collateral value and the cash. For example, if you were to give me bonds worth $100 million, and I was just to give you back $98 million in cash, that's the only loan or deposit that I made, we would call that a 2% haircut. Because the $2 million difference represents 2% of the bond value. Haircuts will play a very large role in what went on during the panic because if haircuts go up, that is effectively tantamount to withdrawal from the bank. If you give me a $100 million worth of collateral and I'm only giving you $98, that's a 2% haircut. But if I suddenly get more nervous about the collateral's value, and I'm only willing to give you, say, $90 for every $100 of collateral. That is as though, I have just come and taken $8 million out of your bank. We're gonna call that the run on repo and discuss that in a later lesson of this module. This table will give a sense of just how important repo finance was to the major broker-dealers. We see here Morgan Stanley, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Bear Stearns, the five major independent investment bank broker-dealers that existed as of the beginning of 2008. And we're gonna summarize some information in this table taken from the most recent SEC filings that they had prior to the financial crisis. So in the case of Morgan Stanley, Goldman Sachs, Lehman Brothers, and Merrill Lynch, that is as of the second quarter of 2008. For Bear Stearns, it's gonna be in the first quarter of 2008 since they didn't exist as an independent firm in the second quarter. In the first line of numbers that you see in this table is the total amount of financial instruments owned by each of these institutions. So the first thing to note is that this is a just very big number relative to what you might have thought the size was from an equity perspective of these institutions. So for Morgan Stanley and Goldman Sachs were right around $400 billion. For Lehman Brothers and Merrill Lynch, right around 300 billion. And for Bear Stearns, about 140 billion. So in total, these five institutions have 1.5 trillion, approximately 1.5 trillion of financial instruments owned. Now how do they finance these? In the next line, we see the total amount of financial instruments that have been pledged as part of repo finance. So, in these cases, for the totals in that row, the institutions are pledging as collateral the assets on their balance sheet. And they're getting back cash. It's effectively how they're paying for, how they're financing and holding in inventory, these financial instruments. For the five firms, you can see in the last row the percentage of all of their assets that they own that are pledged, which represents the percentage that are financed by repo. And you can see that for Morgan Stanley, it's 50%, 39% for Goldman Sachs, 46% for Lehman Brothers, 28% for Merrill Lynch, and 55% for Bear Stearns. Overall, of the 1.5 trillion, 42% are financed by repo, a very, very significant form of finance for all of these broker-dealers. [MUSIC]
