Reforming Repo Rules

CAMBRIDGE – Sometimes, we just don’t learn.

After the financial crisis, the United States enacted the Dodd-Frank Act to overhaul American financial regulation, with the aim of reducing the risk of another financial meltdown. But it did nothing to reform “repo” lending – arguably the weakest link in the financial chain. And we have just seen another major financial firm collapse as a result.

A repo, or repurchase agreement, is a sale of a security (often a US Treasury obligation) that the seller promises to buy back later – often the day following the original sale – at a slightly higher price. The repo buyer thus lends to the seller, with the difference between the immediate “spot” price of the obligation and the “forward” repurchase price representing the interest on the loan. These repo loans give firms – typically financial firms – access to vast pools of cheap financing (often emanating from US money-market funds). It is a market measured in the trillions of dollars.

MF Global, the global financial firm that filed for bankruptcy in October, is just the most recent noteworthy example of how repo lending can go wrong. Like Bear Stearns and Lehman Brothers before they failed, MF Global had huge short-term, repo-based debt. Bear failed in 2008 as its mounting real-estate losses prevented it from quickly rolling over its repo debt, which made up fully one-quarter of its balance sheet. Then, a year later, Lehman failed with one-third of its balance sheet in repo. Repo debt seems to have made up an astounding one-half of MF Global’s balance sheet.