I recently read some good comments on one of the blogs I follow, which explained why Wall Street investment banks’ financial systems were doomed to collapse. Unfortunately I do not remember the source’s name. The following is me paraphrasing what I read:

Investment banks used a daily financing method that was doomed to failure at some point. A secured repurchase agreement (repo) occurs when a borrower temporarily sells a security for cash to a lender with an agreement to purchase the security back, often the next day.

Secured repos are crucial for investment banks, which borrow and lend billions to fund their daily business. Think of it this way: Wall Street firms have an inventory of hundreds of billions of dollars of securities that have been built up over the years (in the case of Bear Stearns, it was about $350 billion of assets). Like Macy’s, the firms try to move this inventory as rapidly as possible, hoping to sell it for more than they paid. In the meantime, like Macy’s, they use those assets as collateral to obtain financing to run their business. While Macy’s uses its inventory and receivables to secure a revolving line of credit with a maturity of around four years, Bear and other Wall Street firms finance part of their inventories in the repo market. They sell their securities to investors at one price and agree to buy them back the next day for a slightly higher price. The difference is the investors’ compensation for providing the financing (the repo rate). It is called “overnight repo” and for years it worked mostly without incident.

If Macy’s creditors had the ability to decide every night whether to finance its inventory, they could pull the plug on the company – especially if they felt Macy’s had loaded the stockroom with questionable merchandise. Macy’s would never do such a crazy thing, but this is exactly how Wall Street operates. Bear’s reliance on overnight repo effectively gave the overnight lenders – such as Fidelity and Federated Investors – a vote on the firm’s viability every night. And during that fateful week in mid-March, those overnight lenders voted a collective no. The result? Bear Stearns did not have enough cash on hand to meet customers’ demands during the run on the bank.

Once overnight lenders lost faith in a firm’s collateral, the firm would have no cash available to run their business. Thus their collapse was inevitable.

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