While I don't understand it, this post is really, really, really important.

Despite the title and the apocalyptic language, Richard Smith and the linked interview with Gary Gorton provide a good overview of the repurchase (commonly called repo but no the same as the guy who takes your car when you miss payments) market and how the shadow banking system works. On top of that, it points to how JP Morgan will end the world through rehypothecation.


I'm going to link a lot of material and none if it is an easy read but some is in layman's terms. Math is hard and I can't do it hence the need to gather context. I'm putting it all here as a reference for myself more than anything else. I also want to apologize to Houston for the long post as I know it irks him (one day my thoughts will look more like i09, today is not that day).


Here's wikipedia and others about some related stuff because the articles aren't written for you and I.
Repurchase Agreement and from Investopedia


Repo 105 and from Zero Hedge: How Lehman Fooled Everyone (Including Allegedly Dick Fuld) And How Other Banks Are Likely Doing This Right Now and the NPR Planet money coverage plus a heplful you tube video about the accounting shenanigans and the official Proceedings Examiner's Report Volume III, Repo 105. Repo 105 is essentially what pushed Lehman into bankruptcy. Once their sources of liquidity dried up they couldn't stay in operation and folded in a matter of days. It triggered the credit meltdown and the market crash of 2008. It led directly to the bailouts and indirectly to McCain's fumbling of the whole matter which cost him the election.


According to the linked Calculated Risk article:
"If JPM pull it off, there will be a big credit multiplier and a big area of Dragon Country for us all to visit. Replaying the ’08 repo crash with 20 rehypothecations rather than 4 gives a system that has $17 trillion of liquidity in it, pre-crash, for every $1 trillion of collateral. Apply the crisis haircuts and $8 trillion of liquidity vanishes. That is Doomsday. All it takes is some solvency doubts; the quality of the collateral makes no difference. Indeed, because of the small starting haircuts, the US Treasuries make a larger contribution to the liquidity loss, if the number of rehypothecations is larger."


I emphasized quality of collateral because a big part of Lehman's repo strategy was to lend riskier collateral at slightly higher rates (it was both profitable and kept bad assets off the books). The kicker was that the riskier collateral was all Mortgage Backed Securities and their slowly customers stopped accepting it after Bear Stearns collapsed. 


The article ends on a mixed note but with some regulatory suggestions:
"So how does one wall off Dragon Country? The ultimate objective must be a UK version of the 1934 Securities Law, which capped rehypothecation quite effectively in the US. Pending that, or as well as, some or all of the following:

• The number of times a given piece of collateral can be rehypothecated is critical. Regulators might consider restricting it.
• Haircuts also matter, especially when they are very small. Regulators might consider increasing the minimum haircut on rehypo’d assets. If haircuts of less than 10% were not permitted, then the credit multiplier could not exceed 10 for any repo collateral, no matter how much rehypothecation there was. If it was 20%, the credit multiplier could not exceed 5.
• Regulators might consider eating some of, or a lot of, JPM’s lunch, by taxing each rehypothecation. The proceeds would build up a fund that provides the liquid assets needed in a crisis…something like an FDIC for repo liquidity.

But I wouldn’t hold your breath; the UK authorities’ response so far suggests that they, like JP Morgan, think unrestricted rehypothecation is a thoroughly good thing. I disagree."