Think of the repo market as the blood vessels of Wall Street. Smooth repo flows = a happy, oxygenated market. But in 2008, the vessels clogged. Suddenly, no one trusted anyone else’s blood type $($read: collateral$)$.
Let’s dissect how repo mechanics fed into the collapse of Lehman and Bear Stearns, explore collateral types, and understand what makes some bonds special.
🧨 Repos During the Credit Crisis
Before 2007, repos were hot and liquid — like Wall Street’s morning coffee.
- Borrowers posted anything from Treasuries to mortgage-backed securities $($MBS$)$.
- Lenders, hungry for yield, didn’t mind taking lower-quality collateral — in exchange for higher repo rates.
But then came the storm. ☁️
💥 Lehman Brothers & JPMorgan: From Tri-Party to Tragedy
- JPM was Lehman’s tri-party repo agent — managing collateral and settlement.
- Lehman needed daily repo loans to survive.
- JPM lent during the day, often without haircuts.
- As market panic rose, JPM demanded more collateral and began applying haircuts even on intraday loans.
By September 2008:
- Lehman owed JPM $100+ billion
- JPM asked for $14 billion more in collateral
- Lehman collapsed — citing JPM’s actions as the final blow
Who’s right?
- Lehman: “JPM bled us dry.”
- JPM: “We kept you alive while others backed out.”
Regardless, one thing is clear: collateral quality and repo terms became fatal.
🤔 If repos were this deadly, how did they affect Bear Stearns?
🧊 Bear Stearns: From Term Repos to Terminal Collapse
Bear Stearns had switched from unsecured commercial paper to longer-term repos. Good idea, right?
It was — until nobody wanted to roll those repos.
- Lenders wanted overnight only
- Required higher-quality collateral
- Asked for bigger haircuts
In March 2008, Bear’s cash was gone and repo funding dried up. The Fed had to step in, and Bear was sold to JPM at a bargain.
🧠 So what’s at the heart of all this panic? Collateral.
🏛️ General vs. Special Collateral
Repos aren’t just about any security. It matters what you post.
🧺 General Collateral $($GC$)$
- Lender says: “Give me any government bond, I’m flexible.”
- No preference for specific bond
- Used for cash management
- Comes with the highest repo rates
The repo rate for GC = GC rate, often just below the federal funds rate.
🤔 But what if a trader wants a specific bond for short selling?
🎯 Special Collateral
- Lender demands a specific bond
- Typically used for:
- Short selling
- Inventory hedging
- Repo rate is lower than GC rate = special rate
This is like borrowing your neighbor’s exact vacuum cleaner model just to match your dock. You’ll accept a lower yield $($interest$)$ for the exact fit.
📈 Special Spread and Auction Cycle
The special spread is: $\text{Special Spread} = \text{GC Rate} – \text{Special Rate}$
This spread behaves like your favorite concert ticket prices — wider before demand spikes $($auction$)$ and narrower right after.
🎯 On-the-Run $($OTR$)$ vs. Off-the-Run $($OFR$)$
- OTR = The latest Treasury issue = Highly liquid
- OFR = Older issues = Less liquid
OTR bonds:
- Get tight bid-ask spreads
- Are great for shorts → easily sold and rebought
- Therefore, become special collateral
Auction pattern:
- Spreads widen before an auction $($bond in demand$)$
- Spreads narrow after $($new supply hits$)$
🚨 Special Spread Floors and Ceilings
Special rates can’t go below zero:
- If you fail to deliver a bond, you don’t get the sale proceeds = lost interest.
- So a borrower might pay 0% repo rate just to secure that bond — but not less.
Also, in 2009, regulators introduced penalty rates for failed trades: Penalty Rate=$\max \left(3\% – \text{Fed Funds Rate},\ 0\% \right)$
So the maximum special spread is bounded by this penalty.
Here’s where math meets profit.
If an OTR bond has a special spread of 0.18% for 90 days, what’s its financing advantage?
Assume \$100 market value. The advantage is: $100 \times \frac{90 \times 0.18%}{360} = \$0.045$
You gain 4.5 cents per $100 of bond just from financing it at a cheaper repo rate.
🤔 And this value is additive to the liquidity premium of the OTR bond.
🧠 Final Thoughts: When Repos Go Rogue
Repos aren’t inherently risky — they’re beautifully structured tools.
But when collateral gets murky and funding dries up:
- Haircuts rise
- Lenders run
- Firms collapse
Add in special spreads, and you have a marketplace that rewards precision — but punishes panic.
🧾 Repo Recap Quick Table
| Term | Meaning |
|---|---|
| Repo | Sale of a security with a promise to repurchase |
| GC Collateral | Any acceptable bond, no preference |
| Special Collateral | Specific bond requested as collateral |
| GC Rate | Repo rate for general collateral |
| Special Rate | Repo rate for special collateral |
| Special Spread | GC Rate $-$ Special Rate |
| OTR | On-the-Run Treasury (most liquid) |
| Penalty Rate | Cost for failed trade delivery |
| Financing Advantage | Cash flow gain from using special bonds |