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Evaluate how repo dealings contributed to Lehman Brothers and Bear Stearns collapsing in the 2007-2009 crisis.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Repurchase Agreements and Financing · FRM2.LTR.13.d

The idea

Repo funding played a central role in the 2008 failures of Bear Stearns and Lehman Brothers. Both dealers financed large inventories of longer-dated and less liquid assets with overnight and very short-term secured funding, mostly through repo, so a large part of their balance sheet had to be rolled every day. When confidence fell, lenders simply declined to roll, raised haircuts or demanded extra collateral, and the dealers faced a funding run despite the funding being collateralised. Bear Stearns lost access to secured funding within days in March 2008 and was sold to JPMorgan Chase with central bank support. Lehman additionally used Repo 105, repos accounted for as sales, to lower its reported leverage at quarter-ends. It failed in September 2008 as repo counterparties and clearing banks pulled back. The lesson is that secured funding does not remove rollover risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits the way repo funding contributed to the failure of Bear Stearns in March 2008?

  1. Its repo counterparties defaulted on returning the collateral it had pledged to them.Why not: Misidentifies the problem: the issue was loss of access to funding, not default by repo lenders.
  2. Regulators banned the firm from entering repo transactions.Why not: There was no such ban; the funding was withdrawn by lenders in a confidence crisis.
  3. It was unable to find securities to deliver in reverse repos it had agreed to.Why not: Not the failure mechanism; the pressure came from financing its own assets in repo.
  4. Its repo lenders stopped rolling its funding as confidence collapsed, producing a run. - correct

Bear Stearns relied heavily on short-term secured funding. When counterparties lost confidence and refused to roll it, the firm faced a liquidity run and was sold to JPMorgan Chase with central bank support.

A harder one

Which statement best distinguishes the role of repo in the Lehman and Bear Stearns failures?

  1. Bear Stearns used Repo 105 to understate leverage, while Lehman was a pure liquidity run.Why not: Swaps the two cases; Repo 105 is associated with Lehman.
  2. Both firms failed because their reverse repo counterparties defaulted on cash owed.Why not: The firms were short-term cash borrowers; the funding withdrawal, not reverse repo defaults, was the cause.
  3. Neither had meaningful repo exposure, as both funded mainly with long-term debt.Why not: Wrong: both relied heavily on short-term repo funding.
  4. Both suffered repo funding runs, and Lehman also used Repo 105 to cut reported leverage. - correct

Both dealers financed longer-dated assets with short-term repo and lost it when confidence went. Lehman additionally used Repo 105 to reduce reported leverage, which weakened market confidence in its reported position.

The hardest tier

A stylised dealer holds assets of USD 200 billion financed by repo at a 5% haircut (cash = MV x 0.95), and equity of USD 10 billion. The assets fall 3% and the lenders raise the haircut on all assets to 8%. Assuming the repo stock is cut back to what the new haircut allows, the cash the dealer must raise (for example by selling assets) is closest to:

  1. USD 11.5 billion - correct
  2. USD 6.0 billionWhy not: Applies the new haircut to the old asset value only; it ignores that the assets have also fallen in value.
  3. USD 15.5 billionWhy not: Uses the full new haircut on the lower asset value (0.08 x 194) rather than the reduction in the permitted loan.
  4. USD 4.0 billionWhy not: Reports the dealer's remaining equity after the loss, not the funding shortfall.

Debt is 200 x 0.95 = 190. Assets are now 194, so the permitted loan is 194 x 0.92 = 178.48. The dealer must repay 190 - 178.48 = 11.52 billion, which can force asset sales and lower prices further.

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