A foreclosure settlement between five major banks guilty of “robo-signing” and the attorneys general of the 50 states is pending for Monday, February 6th; but it is still not clear if all the AGs will sign. California was to get over half of the $25 billion in settlement money, and California AG Kamala Harris has withstood pressure to settle.
Suppose the institutional investor is Fidelity, and Fidelity has $500 million in cash that will be used to buy securities, but not right now. Right now Fidelity wants a safe place to earn interest, but such that the money is available in case the opportunity for buying securities arises. Fidelity goes to Bear Stearns and “deposits” the $500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset‐backed securities [with] a market value of $500 millions. These bonds are provided to Fidelity as collateral. Fidelity takes physical possession of these bonds. Since the transaction is overnight, Fidelity can get its money back the next morning, or it can agree to “roll” the trade. Fidelity earns, say, 3 percent.
In the repo market, banks pledge their securities as collateral for short-term loans from money managers and other investors. The market played a key role in the build-up to the 2008 financial crisis. Banks used toxic assets, such as repackaged subprime loans, to secure trillions of dollars worth of cheap funding.
When the US housing bubble burst, the banks’ trading partners refused to accept such securities as collateral and the repo market rapidly contracted.
However, a study by Fitch Ratings says the proportion of bundled debt being used as security in repo transactions has returned to pre-crisis levels.
Using the repackaged loans can increase risk in the repo market, the rating agency says. This is because the securities may be prone to sudden pullbacks such as the one experienced in 2008.