According to Jeffrey Snider, repo lending in the unregulated, largely invisible Eurodollar markets is the true foundation for the global reserve currency, and repo works because of trust in collateral. When faith in the liquidity of collateral fails, crisis ensues. Failure of trust in collateral liquidity underlies the 2008 global financial crisis (GFC1) and likewise today's GFC2. Then, it was subprime mortgages that became unacceptable as collateral. Today, it's dodgy Eurobonds, collateralized loan obligations, corporate bonds hovering near junk, and who knows what else. Rejection of formerly acceptable collateral unifies both crises. But the central bank responses are simply more of the same, and quite unlikely to have any better effect:
If it feels a lot like 2008 right now that's because, in large part, nothing was learned from the first Global Financial Crisis (hereafter GFC1). That's why everything that's being done in response to the latest one (hereafter GFC2) had already been tried during the last one. Because it all worked out so well in 2008, let's do it all over again? QE's and ZIRP's sounded fantastically new when they were introduced, but today they're just a normal part of the landscape (that's how effective they've been). Dollar swaps and commercial paper facilities. Been there. Done that. Liquidity auctions everywhere. A Primary Dealer Credit Facility. Revolutionary in GFC1, now making its reappearance for GFC2. Only that last one begins to take a stab, and only a half-hearted thrust, at the main immediate problem. Collateral.
Snider's grasp of the workings of shadow money and his mastery of related data are unrivaled. And his contempt for central bankers and economists is unsurpassed. He shines an invaluable light into the dark places where the sausage (money) gets made. Here's a sample, but read the whole thing for maximum effect:
On June 19, 2007, Merrill Lynch seized $850 million worth of CDO's after the [Bear-Stearns sponsored] hedge funds rejected repeated requests to post more collateral. As the housing bubble began to collapse, questions were legitimately raised about the value of assets created during it. . . . After having been refused, Merrill moved in . . . and then regretted ever getting tangled up in this mess. Taking possession of the $850 million, as was its legal right, it tried to auction the CDO's as standard repo practice. This is the whole point of taking collateral; so that if the counterparty borrowing cash from you defaults in any way on its obligations, including provisions about being undercollateralized, you can take ownership of the collateral and dispose of it as you see fit in order to get your cash back. All your cash. This was the bedrock assumption of the repo market, the very thing that made it the central monetary pivot for an exhaustive and expansive global dollar marketplace. Repo is safe because the security of securities. Except, Merrill could only find buyers for $100 million of the $850 it had taken. Suddenly, a cash lender was on the hook for unknown possibly large-scale losses due to a collateralized funding operation. From that point forward, the whole system began demanding more collateral from counterparties who didn't have it; the latter being the whole problem. That was the inelasticity. Merrill's dilemma demonstrated the system's primary weakness; repo only works so long as the collateral remains fluid and liquid itself. That's the whole point; the funding only flows when the collateral does. No cash lender is ever supposed to wonder about the security they're taking for lending that cash. If they're not absolutely sure they can sell it tomorrow, and on what terms, the whole thing is off. Since repo is the real backbone and backstop, the cascade of collateral paralysis becomes an unstoppable tidal wave . . .