This repo market instability became evident in March 2008, when rumors were swirling about Bear Stearns’ financial condition. Counterparties did not want to risk holding collateral that could only be sold at fire sale prices in the event of a Bear Stearns’ bankruptcy – so they refused to lend to Bear against anything but the highest quality collateral. Since Bear Stearns financed half of its balance sheet on the repo market, this withdrawal of credit was disastrous. In the absence of credit drawn on repos Bear did not have the liquidity necessary to meet its short-term obligations.
In the case of Bear Stearns, fear of a bankruptcy filing precipitated a withdrawal of credit that made bankruptcy almost inevitable – and destroyed the firm. In September 2008 Lehman Brothers collapsed when it too faced a bank run as fellow bankers withdrew credit and issued collateral calls. At the time of the Lehman failure, Merrill Lynch was at risk of the same treatment and was saved only by Bank of America’s eleventh hour purchase. Within days Goldman Sachs and Morgan Stanley were also at risk – exactly one week after Lehman filed for bankruptcy the Federal Reserve announced expedited approval for the transformation of these firms into bank holding companies with full access to the Fed’s support for commercial banks.
In short, every firm that relied on repurchase agreements as an important source of funding – and did not have full access to the liquidity facilities of the central bank – faced a bank run and either failed or was rescued. Safe harbor for repurchase agreements that are backed by securities of limited liquidity sets up an institutional structure that is prone to bank runs. Whenever there is some small likelihood that a firm a might declare bankruptcy, counterparties protect themselves from the possibility of losses in a fire sale by withdrawing credit from the firm – and driving it into bankruptcy. The repo markets we have now can only be described as fundamentally unstable.
The financial instability created by the run on Bear Stearns forced the Federal Reserve to take extraordinary action. The Fed appealed to its authority under section 13(3) of the Federal Reserve Act to lend in exigent circumstances to financial institutions that were not commercial banks. This authority was last exercised more than 50 years ago.
Using its emergency powers the Fed initiated two programs in March 2008: the Term Securities Lending Facility and the Primary Dealer Credit Facility. The Term Securities Lending Facility allows investment banks to temporarily trade highly rated private sector debt for Treasury securities. In the Primary Dealer Credit Facility the Fed lends to investment banks against investment grade collateral. Both of these programs were clearly designed to deal with the collapse of repo markets trading less liquid securities. In addition, the Fed lent $29 billion to JP Morgan Chase to facilitate the purchase of Bear Stearns. This loan was extraordinary because it was a non-recourse loan – in other words, JP Morgan Chase has the legal right to walk away from the loan leaving the Fed with only the collateral as payment.
As a consequence of the March 2008 collapse of the repo market, the Federal Reserve was exposed to private sector credit risk. By the start of September it held as much as $100 billion of private sector assets that had been traded temporarily for Treasuries. September was a disastrous month for the investments banks. On September 14, the day before Lehman Brothers filed for bankruptcy, the Fed agreed to accept all collateral that had commonly been used in repo markets – including collateral that was not investment grade – in the Primary Dealer Credit Facility and extended the Term Securities Lending Facility to include all investment grade securities, not just those that were AAA rated. (Lehman did not have access to these programs, because it did not meet the Fed’s criteria for a sound financial institution.) By October 1st, the investment banks had borrowed almost $150 billion directly from the Fed. This, in addition to $230 billion of private sector assets temporarily exchanged for Treasuries.
In short, the collapse of the repo market in 2008 forced the Federal Reserve to intervene to protect the financial system by exchanging the risky assets that had been used as repo collateral for cash and Treasuries – the Fed chose in 2008 to act as a lender of last resort to the market for repurchase agreements. As of mid-2009 these programs had shrunk to almost nothing, indicating either that the investment banks have found other sources of financing – possibly due to their new status as bank holding companies – or that repo markets have to some degree recovered. Now that the crisis in the market for repurchase agreements is over, we can take the time to evaluate whether this is an appropriate role for the Federal Reserve or whether the repo market itself needs to be reformed.
 CARRICK MOLLENKAMP, SUSANNE CRAIG, JEFFREY MCCRACKEN and JON HILSENRATH, Oct 6, 2008, “The Two Faces of Lehman’s Fall,” Wall Street Journal.
 Neil Irwin, July 21 2009, “At NY Fed Blending in is part of the job,” Washington Post, http://www.washingtonpost.com/wp-dyn/content/article/2009/07/19/AR2009071902148.html?wprss=rss_business indicates that Sept 18 is the date the New York Fed realized GS and MS were facing runs. Federal Reserve Board, September 22, 2008 “Order approving formation of bank holding companies”
Gary B. Gorton, 2009, “Slapped in the face by the invisible hand” (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882) documents the withdrawal of credit from the repo market in the form of increasing haircuts – and discusses its similarity to a bank run.
 This may not represent the full extent of Federal Reserve lending to investment banks on October 1, 2008 as both Morgan Stanley and Goldman Sachs were now bank holding companies and could access liquidity facilities like the discount window and the Term Auction Facility.
10-6-09 update note: Corrected error regarding TSLF.