Whatever the Fed does, this crisis has a long way to run

Generations of bankers have been able to pass entirely respectable and quite successful careers in the City without ever having to trouble themselves to understand the workings of the repo market. But that is not a luxury available to anyone who wants to understand the full horror of the current credit crisis, or why the US Federal Reserve this week felt obliged to mount an extraordinary $200bn bail-out operation on Tuesday.

Blaming the latest bout of market turmoil on the collapse of a couple of hedge funds London-based Peloton blew up last month and Carlyle Capital Corporation is currently on the brink doesn't begin to capture the enormity of what is going on. This is complex stuff, but bear with me.

The repo market is central to the City, but is usually so uncontroversial that we never hear about it. Its function is to allow banks, hedge funds and other financial institutions to borrow money against portfolios of bonds, loans, mortgage securities and other credit securities and juice up returns. The amount you can borrow will depend on the quality of your collateral the repo desk will lend the market value of the bonds minus a "haircut".

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During the boom when risks of default were considered minimal, repo desks were prepared to lend vast sums for long periods with minimal haircuts. A hedge fund manager wanting to repo an AAA-rated bond might borrow up to 50 times his money. At that level, it would take a mere 2% fall in the value of the security to wipe out his investment. But so long as the bond held its value, the hedge fund was able to pocket the tiny difference between the yield on his bond and the cost of his borrowing, which, multiplied by 50, would translate into a decent return on his equity.

What has happened over the last few weeks, however, is that the repo market has seized up. Banks are changing their terms refusing to lend money for more than about 30 days, where once they might have offered 180 days, and taking bigger haircuts. That's partly because the prices of assets once considered solid have started to fall as default fears rise. It's partly because banks have so many calls on their capital that they are desperate to cut back on all lending.

But it's mainly because the market is now gripped in a spiral of fear. Distressed investors, including hedge funds and bank proprietary trading desks are "puking" assets, as the market charmingly puts it. Firesales are causing asset prices to plummet, wiping out the equity of leveraged funds, leading to fresh firesales. Peloton, for example, blew up when the AAA-rated mortgage securities it held fell from 97 cents in the dollar to 92 cents in a few days.

So no one feels safe. The natural inclination of any repo desk is to cut its exposure to any asset before trouble emerges. But the very act of tightening financing terms means that trouble is emerging even when nothing has actually gone wrong.

How does this all end? There are no easy answers. The Fed's massive intervention this week was in large part aimed at halting this process. But it is a very high-risk strategy. The Fed and other central banks have effectively agreed to become a repo market of last resort, making $200bn available and accepting a staggering range of collateral. They hope this action will halt the spiral of fear and encourage repo desks to keep financing assets on reasonable terms.

What makes this strategy high-risk is not just the familiar fears over moral hazard that governments are effectively bailing out the financial system, protecting bankers from the consequences of their mistakes but that it will merely delay the inevitable, and in doing so, make the final reckoning worse. The danger is that by not allowing nature to take its course, central banks are condemning the financial system to death by a thousand cuts a drip-drip of writedowns that saps confidence and ultimately feeds through to the real economy, making the downturn longer than necessary.

The alternative approach would be to recognise that, rather than trying to shore up prices, the only way to end this crisis is to let them find their floor. At some point, assets will reach a level at which they become bargains. When is not clear. But if you could buy those AAA-rated securities that did for Peloton for 80 cents in the dollar and held them to maturity, you'd make a 25% return on your money, assuming no defaults with no need to leverage the investment 50 times. That's surely a bargain in anyone's book.

Of course, this approach is high risk too. Its virtue is that it would crystallise the full losses from the credit bubble, ending uncertainty and letting new capital into the banking system. The snag is that by the time the floor is reached, banks would have been forced to recognise such huge losses that many would fail and the system might collapse. That's effectively what happened in America in the 1930s and it's not a risk any government will take. So we're left with the Fed's attempt to shore up the repo market and the certainty that this crisis has a long way to run.

Simon Nixon is executive editor of Breakingviews.com