Guest Post: A Repo Puzzle - What Happened in July-August 2007?

Tyler Durden's picture

A Repo Puzzle:  WTF Happened in July-August 2007?


Nothing moves a subject forward like exploring open problems.  Think of this as a first (actually second) entry in a collection of puzzles, hopefully added by more than just myself.  In the tradition of the Scottish Book, each entry will include an attribution/dedication, a problem statement, data that provide some motivation, and associated hypotheses, and conjectures.    

Since anonymous attribution (JM) is nonsense, the problem is dedicated to Lisa Murphy of Bloomberg.  The problem may or may not be significant.  It is not necessarily an indication of financial apocalypse.  In fact, there may be a simple, trivial answer, which would be stupid.  It’s Lisa Murphy’s problem.

Problem:  The repo market for corporate bonds experienced a six sigma+ delivery fail event.  Why?

A part of the puzzle is that this event was isolated to corporate bonds delivery.  MBS, Treasuries, and agencies saw no such spike in July-August of 2007.

The exact dates of these corporate bond delivery fail events were the weeks of 7/4/2007 (98,608); 8/15/2007 (80,505); 8/22/2007 (92,605); and 8/29/2007 (100,965). 
Hypothesis 1:  It’s a thin market issue.

Even now, corporate securities are not a big part of repo financing.  Treasuries, followed by MBS, dominate the repo financing market.

Amount outstanding as of December 29, 2010.       
When supply is tight, then repo security delivery is naturally more difficult.  When supply is thin in the first place, you have the potential for those bottle-rocket moves.  However, this doesn’t explain that it was essentially a unique occurred for 28 days within a 3,833 day period.   

Hypothesis 2:  Delivery fail spikes in Treasury markets clearly coincide with these securities going special, which is in turn associated with firesales in risk assets. Can this connection between repo funding and delivery fails explain risk premia across asset classes?

Conjecture 1:  Given Hypothesis 2, are these increasing delivery fail event an indicator of dwindling issuance impacting a large modality of security financing? Check out the sustained delivery fails in MBS security repos throughout 2010.

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dick cheneys ghost's picture


10,000 foreclosures halted in Maryland.

A Man without Qualities's picture

Good spot.

One key aspect is the court's requirement that, in order to represent the foreclosure, the banks must have shown an attempt to restructure the debt, which begs the question, what does this mean for junior mortgages?

I continue to believe the weak link for the TBTFs is the second lien/ junior mortgages. You can see some of the exposures below, but it works out about $425bn between the big four.

hooligan2009's picture

Since repo fails do not cause a couterparty to collapse and be banned from trading, repo fails are a function of price and utility. If there is a financial advantage to a fail then it will fail, if you don't want to hand the repo bonds back because you actually need them, then it will fail also. The only other thing I can think of is computer failure. So for me it is not risk premia so much as hard cash advantage, "screw you, you can wait" or (6 May type) system failure.

hooligan2009's picture

don't think there were any repo 105 or the like issues around at that time.

jm's picture

The funny thing is this wasn't a general repo fail issue.  It was corporate bonds.  Other delivered assets went off without a hitch.  Puzzles.

cswjr's picture

Puzzle indeed.  I don't know why you would want to hold on to corporate bonds, specifically.  Only thing I can think of is a rehypothecation issue where C fails to repay B, then B fails to repay A and hangs on to the collateral from C.  That'd give you two repo fails.  Were corporate bonds repothecated more than UST?  Or, more likely, corporate bond repos during that time were riskier and subject to bigger haircuts -- only given to those desperate for cash, and thus more likely to default.

jm's picture

I always thought that Ts dominated rehypothecation in the states and Europe had a penchant for inflation-indexed govt securities.  But I could be wrong.

Usually haircuts are procyclical to de-risking and there wasn't much derisking going on at the time I don't think.  In the crisis of 2008, haircuts for HY reached 40%, which has its implications.  HG haircut was closer to 10% top of mind.

Not discounting what you are saying, just add info.

Was Bear Sterns already hurting at the time and did they do proportionately more corp bond repo?


cswjr's picture

Makes far more sense to rehypothecate Treasuries.  Just sort of thinking out loud.  The Bear Stearns question is a good one, though; I don't know the answer, but now I'm curious and I'll dig around a bit.

PragmaticIdealist's picture

Not puzzling - corporate bonds were highly naked shorted and got caught with the elimination of the grandfathering position in Reg SHO.


Wikipedia: In June 2007, the SEC voted to remove the grandfather provision that allowed fails-to-deliver that existed before Reg SHO to be exempt from Reg SHO.

With the removal of the grandfathering position on naked shorting, investors scrambled to close out naked short positions before Reg SHO kicked in and raped them.

jm's picture

This would explain a repo fail and a big move given thin supply.  But wouldn't this impact other collateral in the same way?

I would expect a spike across all deliveries...

PragmaticIdealist's picture

Question 1.4: Does Regulation SHO apply to bonds?

Answer: Regulation SHO applies to short sales of equity securities. The term “equity security” is defined in Section 3(a)(11) of the Exchange Act and Rule 3a11-1 thereunder (17 CFR 240.3a11-1). A security convertible into an equity security is an equity security. Therefore, short sales of bonds that are convertible into equity would be subject to Regulation SHO. The Staff will consider on a case-by-case basis securities, including structured products, to which the “equity” status may not be clear.


jm's picture

It's not my problem.  It's Lisa Murphy's.  I propose a problem, name it after a pretty girl, and "let it go".

JW n FL's picture


JW n FL's picture

"Check out the sustained delivery fails in MBS security repos throughout 2010."


and or add ______________________ .Gov <--------  there.

mark mchugh's picture

This is my two cents on this matter.  I would invite anyone curious on this matter to carefully review Cramer's infamous, "THEY NO NOTHING" rant. August 3, 2007 Among the topics mentioned:

Bear Stearns (Trading at $109)

Lehman CEO Dick Fuld's trading practices

The Fed's discount window (cutting the rate)



Washington Mutual (take that yield)

For the record, I have always viewed this as a contrived rant, that Cramer was put up to (probably by the Fed itself).  That said, Cramer might be a good person to ask, if you could believe anything he says.

Id fight Gandhi's picture

Contrived indeed. Give the bankers all the want or else.

Seeing him carry on not a year later that bear sterns was strong is a disaster.

Cammy Le Flage's picture

Frankly Tyler - we should all not care anymore what happened it 2007.   Guess what it was - probably fraud of some sort and included some major lying and included members of "regulatory bodies".   Wow.  Who would have thunk it.    The list of disgusting is so long. 

This is a fun read: "Dictator Cribs"

oogs66's picture

Here is what i believe happened.  The entire street had on the 'basis' trade.  Long corp bonds, short CDS.  It was pick 20-50 depending on the credit, the bond, convexity, lbo name, etc.  As pressure hit ABX that summer, there was also pressure on the corporate bond market.  Bonds significantly underperformed as all the fast money was short CDS and the traditional bond buyers were in trouble from the ABX and MBS holdings.  Hedge funds sold bonds to the street, who was also looking to get out of bonds.  The street had trouble liquidating their inventory.  As the bond market became offer side only, some smart funds got short corp bonds.  They would hit what would appear to be a low bid.  With the beauty of TRACE and fear from ABX market, everyone was forced to mark bonds at these prices, prompting more selling.  MER in particular, I believe, had significant balance sheet pressure at month and quarter end so also put pressure on bonds without as much pressure on CDS.  In an effort to stop the pain, dealers, who traditionally leant bonds without a second thought, pulled the borrows, both to cause a squeeze and to prevent shorts from adding to the pain of the basis trade.


PragmaticIdealist's picture

Wikipedia: In June 2007, the SEC voted to remove the grandfather provision that allowed fails-to-deliver that existed before Reg SHO to be exempt from Reg SHO.

Mystery solved: With the removal of the grandfathering position on naked shorting, investors scrambled to close out naked short positions before Reg SHO kicked in and raped them.

AUD's picture

July - August 2007 was when the corporate bond market first began to flop, not coincidently so did the sharemarket.