Early next year, when Congress once again threatens to default on U.S. debt, you are going to hear more predictions of doom. Should you be concerned? Yes.
Let me explain this by going back to 2008. That year, as home values tanked, the financial markets erupted into a full-blown crisis. This happened for the same reason that experts warn of disaster if the U.S. defaults on its debt: The repurchase market failed.
Likely you never heard of the repurchase market. What is it?
Simple. It's where giant financial institutions in the U.S. and Europe borrow $7trillion from one another, every day, often just for overnight. That's $7 trillion. Every day. Just for overnight.
The main borrowers are the world's biggest banks. They use this borrowed money to make investments and loans throughout our economy. The main lenders are money market funds.
Other players are large mortgage companies, investment banks, corporations, insurance companies, pension plans, university endowments, municipalities and anyone with a big pool of money to lend.
If this market freezes, as it did in 2008 and might do again in the event of a U.S. default, the flow of credit throughout the country is dramatically impaired. What can make the repurchase, or "repo," market freeze?
That's where mortgages and U.S. debt come in. To get a repo loan, a financial institution has to put up some collateral, usually pools of mortgages or U.S. debt called Treasuries. If the lender decides it doesn't like the collateral, it won't make the loan. Since repos are very short-term loans, often just for overnight, repo lending can stop on a dime and the repurchase market can freeze in a matter of days.
That's what happened in September 2008. Repo lenders lost faith in the mortgages they'd been taking as repo collateral. They stopped lending. Giant financial institutions could not get money.
Federal Reserve Chairman Ben Bernanke told Congress that in September and October of 2008, "Out of maybe the 13 most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two."
This is what turned a real estate bubble into the worst financial crisis since the Great Depression. Could it happen again, for example if lenders lose faith in Treasuries? You bet.
If you've read this far, let me admit I've vastly oversimplified the repo story. Interesting things happen on that market.
For example, collateral can be reused. If a borrower puts up $100 million in Treasuries as collateral for a repo loan, the repo lender can use those same Treasuries as collateral to get a repo loan for itself, and the next lender can use the same Treasuries as collateral to get a repo loan for itself.
Usually these are overnight loans that the lenders renew the next day. But imagine how interesting it gets when one of the lenders in the chain wants its money back. Why is this market called the "repurchase" market? Because transactions take the legal structure of a purchase. The borrower "sells" its collateral to the lender and promises to "repurchase" it soon, often the next day.
The Fed conducts much of its monetary policy on this market. When you read that the Fed may soon start selling the securities it bought during the recession, what the Fed will actually do is use those securities as collateral for a repo loan. Then the lender to the Fed can use those same securities as collateral.