Repo fear

Contagion: When the financial crisis took hold in 2008, negative feedback loops accelerated the transmission of fear through the financial system. Something similar may be happening as contagion spreads through the euro zone.

Take repo, a sort of pawnshop lending where banks post collateral in return for overnight loans from conservative money funds. Before their collapse, US securities firms Bear Stearns and Lehman Brothers were heavily dependent on this form of financing. But repo lenders began demanding more collateral margin to cover their loans and finally fled the market completely, helping put Bear and Lehman out of business.

In Europe, repo has become a vital conduit of wholesale funding for commercial banks. Most lending goes through a single counterparty, LCH.Clearnet, which accepts European Union sovereign debt as collateral and sets margin requirements. LCH.Clearnet's recent decision to raise Irish debt margin requirements was, most agree, a vital self-protective mechanism.

However, worthy self-protection can easily become part of the problem. Suppose that LCH.Clearnet raises margins on Portuguese collateral by 15 per cent — as traders think it will. An over-leveraged bank struggling to fund ¤10 million in Portuguese bonds will suddenly only be able to fund 8.7 million of that.

If the bank doesn’t want to sell the Portuguese bonds at a loss, it will have to sell something else to raise cash — say Spanish bonds. If a lot of banks do that at once, then Spanish spreads will widen, an example of contagion at work.

Then there are credit default swaps. Banks worried about loan exposure to Ireland and Portugal might buy CDS. Protection buyers flood the market, traders quote wider and wider spreads until protection sellers meet the demand. But if sellers can’t be found, trading desks might hedge their exposure by buying protection on the next best thing — Spain, whose spreads widen as a result. In 2008, the Federal Reserve had to prop up these shadowy markets, and today, the European Central Bank is supporting repo lending, with 10 per cent of Irish and 7 per cent of Portuguese bank assets funded in this way, according to Morgan Stanley. The worrying lesson of 2008 was that what the Fed initially thought sufficient proved wildly incapable of doing the job.