After world capital markets bottomed in March this year the first question was — is it safe to go back into the water? Since then equity markets have rebounded off that low by variously 50%-60%. During this unprecedented (and many Bears would say unfounded) meteoric shot for the moon back towards the black, the question has become — is it safe to stay in the water? But really now, shouldn’t the question have always been — what the hell am I swimming in?

Throughout 2008 I knew the stability (instability!) of the US markets had to do with their Triparty Repo system (repurchase agreements), but getting a clear understanding about what was really going on with repos was difficult, with only part of the story ever being available.

The repo system is a central mechanism for financial institutions to raise cash by pledging collateral — it is key to the idea of “fast money”. The really hot part of the system is the overnight repo market, where banks and financial institutions daily roll, swap and change their available collateral to renew their loans for every type of financial product purchase under the sun. The Triparty Repo system simply has a banking intermediary (the third party) acting as a clearing house between the borrower and a lender — this intermediary (such as JP Morgan, for instance) will check the lender’s collateral before releasing the funds provided by a willing lender.

This whole repo system was valued at least $US4.5 trillion dollars in March of 2008, and it was this part of financial sector that seized and stopped functioning with the collapse of Bear Stearns in the same month of that year.

Shortly after the collapse of Bear Stearns and speculation began to run rife that the Fed Reserve had been somehow lending a supporting hand to US equity markets —  where the Reserve was said to be part of an almost fabled Plunge Protection Team (PPT) as it became known in financial circles — where the Fed Reserve possibly playing in the equity market is of course a big no-no.

Well now that the dust has finally settled a little bit on the chaotic goings-on of 2008, people have been starting to ask and investigate the real questions such as — what stopped us all from going over that cliff we were all told we were standing on?

One relentless investigator scratching below the surface of the political rhetoric and the spin of the Federal Reserve is Tyler Durden (yes, the character immortalised by Brad Pitt in Fight Club) of the hard-hitting financial website Zero Hedge, where a couple of days ago he pushed out a story that provides the dirty details behind the US repo system’s crazy days of 2008.

Let’s be clear — the US repo market should have been allowed to collapse for a time after it seized-up when Bear Stearns fell over — the system needed to be flushed clean. Instead, within days it was up and functioning again, ensuring a return to bullish momentum trading in equities across all markets. But why didn’t it remain seized? Then Lehman Brothers went and filed for bankruptcy on  September 15, 2008 — surely the repo market couldn’t sustain a collapse of those proportions? But the financial system kept rolling on — again, how?

As if often the case for even the most complex of systems, that the reason for their continued operation is quite simple — the repo market is no different — its key is collateral. In a nutshell the Fed Reserve of America stepped in just before it knew Lehman Brothers was about to collapse, and told all of its 21-odd primary dealers (private sector finance institutions who stand at the beck and call of the Fed to do most of its bidding), that the Fed would directly enter the repo system as a massive lender under the guise of the Primary Dealer Credit Facility, where as lender of last resort the Fed completely surrendered prudence (that is, it placed at great risk taxpayer dollars) and allowed even securities of near bankrupt companies to be pledged as collateral — yes, securities of near bankrupt companies — so to insure money could be lent to primary dealers such as Goldman Sachs, JP Morgan and UBS to gun the markets.

In essence through the use of its primary dealer network, the Federal Reserve became a de facto purchaser of equities by any speculative means chosen by its primary dealers. And do you think the Fed’s primary dealers took advantage of this essentially free money to go speculate their -sses off — well take a look at the below explosion:

So what did we get for all this? Despite all the talk about the GFC being due to credit being too easy, where even the Fed Reserve has doled out this line repeatedly before US Congress, we can now see that the Fed itself became and remains a primary source of easy credit — it does own the printing presses on the world’s fiat currency after all, so you can’t get any more “primary” than that.

Result: the bubble in capital markets based on speculative and momentum trading has been maintained wholesale. Today we have capital markets and particularly equities held aloft by technicals and easy/free credit from the Fed also, where regard for the fundamental health of companies and the economy as a whole, or the principles that use to establish the correctness and need for bankruptcies has been deemed old-world and quaint. Our childhood fascination with bubbles is understood — they look pretty — but please remember what happens with all bubbles — caveat emptor, especially you baby boomers.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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