E-coli, Repo Madness, and the Financial Crisis

All bond prices plummeted (spreads rose) during the financial crisis, not just the prices of subprime-related bonds. These price declines were because of a banking panic in which institutional investors and firms refused to renew sale and repurchase agreements (repos)—short-term, collateralized, agreements that the U.S. Federal Reserve rightly used to count as money. Collateral for repos was, to a large extent, securitized bonds. Firms were forced to sell assets as a result of the banking panic, reducing all bond prices and creating losses. There is nothing mysterious or irrational about the panic. There were genuine fears about the locations of subprime risk concentrations among counterparties. This banking system (the “shadow” or “parallel” banking system)—repos based on securitization—is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit will not be created.