LO 51.4: Assess the role of repo transactions in the collapses of Lehman Brothers

LO 51.4: Assess the role of repo transactions in the collapses of Lehman Brothers and Bear Stearns during the (20072009) credit crisis.
Prior to the 20072009 credit crisis, the repo market was considered relatively liquid with stable demand by both borrowers and lenders. Borrowers often posted weaker quality collateral, including corporate bonds or mortgage-backed securities. This benefited both borrowers, who were able to post less desirable collateral, and lenders, who were able to obtain higher repo rates in exchange for accepting lower quality collateral. However, as the crisis escalated, lenders were reluctant to continue to accept these securities, and were increasingly demanding higher quality collateral and larger haircuts. At the extreme, they simply withdrew liquidity and stopped transacting in the markets. Borrowers that were the worst hit experienced collateral liquidations, capital declines, and ultimately bankruptcies. The case studies of Lehman Brothers and Bear Stearns provide important insights into the role of repo transactions in the demise of these once important institutions.
Repos and Lehman Brothers
JPMorgan Chase & Co. (JPM) was the tri-party repo clearing agent of Lehman Brothers Holdings, Inc. (Lehman). (In a tri-party repo agency arrangement, the repo trades are still executed between two counterparties; however, the collateral selection, payment, settlement, and repo management is outsourced to a third-party agent. Agents are essentially custodians and do not take on the risks of the transactions.) These tri-party repos were traded in the overnight market, and were transacted predominantly between institutional repo lenders and financial institution borrowers (including Lehman). Given that the trades were overnight transactions, they matured each morning, leaving the borrowers without funding during the rest of the day. To bridge this funding gap, JPM, as tri-party agent, was lending directly to Lehman on a secured basis during the day, typically without requiring haircuts on intraday advances. By August 2008, however, due to the increased risk in the repo markets, JPM began to phase in haircuts on intraday loans, with the loan amounts exceeding $ 100 billion in the final week of Lehmans bankruptcy.
Professors Note: Lehman was one o f the largest U.S. investm ent banks. The failure o f Lehman in September 2008 was the largest in U.S. history ($600 billion in assets).
Both Lehman and JPM provide different viewpoints of the events leading up to Lehmans bankruptcy in September 2008. Despite the differing accounts, it is clear that the liquidity and value of collateral pledged in repo transactions declined during the crisis, and additional collateral and additional haircuts were necessary to mitigate the risks in repos.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
According to Lehman, JPM, despite a conflict of interest due to its agent and lender role, breached its duty to Lehman and took advantage of its insider status (being insider to Lehmans internal financial condition and proposed business plans). Lehman accused JPM of using its influence to drain close to $14 billion in collateral from Lehman during the last few days before the bankruptcy, despite already being in an overcollateralized position. Although Lehman agreed at the time to provide additional collateral, it did so unwillingly and simply because there were no viable alternatives.
According to JPM, however, JPM acted in good faith by providing continued funding to Lehman up until the last day, despite Lehmans deteriorating financial condition. When it became clear that the collateral posted to JPM by Lehman was illiquid with apparently overstated values, JPMs exposure to Lehman was growing at a time when Lehmans creditworthiness and financial condition was deteriorating. Nevertheless, JPM continued to lend money despite inadequate haircuts and collateral values. The close to $14 billion in additional collateral requested by JPM was significantly less than what was needed to cover JPMs true exposure.
Repos and Bear Steams
Prior to 2007, Bear Stearns Companies, Inc., (Bear Stearns) relied on funding its borrowings primarily in the form of short-term unsecured commercial paper. By 2007, however, Bear Stearns switched from unsecured borrowing to a more stable form of borrowing through longer term, secured repo financing, which better positioned the firm to withstand market liquidity events. Given the high-quality collateral posted, the firm was able to obtain financing at favorable rates on a term basis.
Given the events of 20072009, lenders during this period became increasingly less willing to provide loans in the form of repo trades, and were especially averse to providing term (rather than overnight) repos. This led to a general shortening of repo terms, requiring larger haircuts, and requesting borrowers to post higher quality collateral. In early March 2008, Bear Stearns experienced a run on the bank that resulted from a general loss of confidence in the firm. This bank run led to a massive withdrawal of cash and unencumbered assets (i.e., assets that have not been committed or posted as collateral), and lenders refused to roll over their repo trades. The rapid decline in market confidence and withdrawal of capital ultimately led to Bear Stearns collapse.
Professors Note: Bear Stearns was a U.S. investm ent bank and brokerage firm that was bailed out by the Federal Reserve Bank o f New York and subsequently sold to JPM in M arch 2008.
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