August 14, 2020

Friar Finance 101

posted on: Thursday March 18, 2010

Investment banks like Lehman Brothers used repurchase agreements before they collapsed. Repurchase agreements, or repos, are contracts for the sale and future buy-back of financial assets. In other words, firms using repos are able to raise cash to fund their operations by posting high quality assets in exchange and promising to repurchase them within the given time period. On the “termination date” the seller will repurchase the asset at the same price it was sold plus interest accrued. Basically, a repo is a short-term interest bearing loan with collateral backing. The interest rate paid on these repos is known as the “repo rate.” Although repos can be of any duration, they are usually overnight loans. The overnight rate runs slightly below the Fed funds rate, or the rate at which private banks lend to each other because repo transactions are backed by assets and Fed Funds are not.When Lehman Brothers was beginning to fall they were having trouble with their repo loans. According to Susanne Craig and Mike Spector of The Wall Street Journal, one particular problem Lehman had was “contradictory agreements” with their lenders. For instance, Lehman had given collateral to J.P. Morgan Chase & Co. in a repo that consisted of a security called “Fenway,” which Lehman claimed had a value of $3 billion. J.P. Morgan, on the other hand, concluded that the security was worthless just days before Lehman went bankrupt. This forced J.P. to ask for additional collateral from Lehman, one of the main factors leading to their demise.According to Stephen Lubben, a professor at Seton Hall University’s law school who specializes in bankruptcy and corporate debt, “the basic problem is that the investment banks have become highly dependent on the repo markets for their funding … but they were using a whole bunch of nontraditional securities for those repo agreements.” Some of these nontraditional securities included Mortgage Backed Securities which fell in value significantly during the financial crisis. When these securities became worthless firms, they would no longer have the ability participate in repos without posting additional collateral.

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