The repo market: a faultline waiting for a crisis?

A source of vast leveraging.

In 1987, having been swept from the Oxford University metallurgy department to Wall Street, I was given a grim warning at a meeting. “We have exacting standards. Only the very best will succeed on our graduate training program. For those of you who do not make it, your fate lies here…” at which our eyes were directed towards a row of desk-bound troglodytes feasting upon pizza at seven in the morning. It was the Repo desk.

If capitalism really is doomed to go through periodic crises then you are well advised to look for the next problem in the place where you previously thought inconsequential. In the 1990’s a curiosity evolved that allowed investors to insure against a company going bust these days known as credit default swaps.  Eighteen years later, after the hilarity had died down and we’d all wiped a collective tear from our eye, credit default swaps brought down AIG, caused the biggest bankruptcy in corporate history and contributed to the near-vaporization of the global financial system.

The same can be said of the repo market – on the face of it, it looks like nothing but has an underlying menace we should take notice of.  Repo stands for repurchase and it works the same way as pawnbroking. You take a watch to a pawnbroker and borrow money against it. A week later you have to pay back the money plus interest to get the watch back, or repurchase it. The repo market merely uses financial securities, such as government bonds, for collateral, instead of watches. It sounds like a simple and safe thing to do but in the wrong hands it can be deadly.

The danger comes from the fact that it allows people with no money to access vast amounts of securities. A hedge fund or bank can buy securities THEN go looking for the money to pay for them through the repo market. All is well as long as you are earning more on the securities than you are paying in interest for the repo market loan that pays for them. But if the market value of the securities begins to fall you are in real trouble.

Nobody knows how large the repo market actually is. Estimates range between ten to fifteen trillion dollars or bigger than the annual income of the entire United States. But what we do know is that the process of quantitative easing has pumped the system up with lots of cheap money. At the same time our central banks have given those who use the repo market the confidence that their securities (bonds and equities) won’t fall in value. It’s a poisonous combination: a rise in borrowing costs combined with a decline in the value of securities would lead to a stampede for the door and someone will get trampled on. Federal Reserve chairman Ben Bernanke in a recent, seemingly innocuous, speech let the cat out of the bag when he said that “More work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.” In other words, it’s coming. Low interest rates and stable securities values won’t last forever. Someone is going out of business.

Psychologists put our periodic crises down to people’s inability to self-limit. Anthropologists put it down to western culture’s inability to join up the various silos in society to reveal the whole, faulted, picture. In reality, to spot the next crisis all you have to do is follow the money: it’s with the troglodytes on the Repo desk.

Head of Fixed Income and Macro, Old Mutual Global Investors

David Young
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The Tories are the zombie party: with an ageing, falling membership, still they stagger on to victory

One Labour MP in Brighton spotted a baby in a red Babygro and said to me: “There’s our next [Labour] prime minister.”

All football clubs have “ultras” – and, increasingly, political parties do, too: although, in the case of political parties, their loudest and angriest supporters are mostly found on the internet. The SNP got there first: in the early days of email, journalists at the Scotsman used to receive bilious missives complaining about its coverage – or, on occasion, lack of coverage – of what the Scottish National Party was up to. The rest soon followed, with Ukip, the Labour Party and even the crushed Liberal Democrats now boasting a furious electronic horde.

The exception is the Conservative Party. Britain’s table-topping team might have its first majority in 18 years and is widely expected in Westminster to remain in power for another decade. But it doesn’t have any fans. The party’s conference in Manchester, like Labour’s in Brighton, will be full to bursting. But where the Labour shindig is chock-full of members, trade unionists and hangers-on from the charitable sector, the Conservative gathering is a more corporate affair: at the fringes I attended last year, lobbyists outnumbered members by four to one. At one, the journalist Peter Oborne demanded to know how many people in the room were party members. It was standing room only – but just four people put their hands up.

During Grant Shapps’s stint at Conservative headquarters, serious attempts were made to revive membership. Shapps, a figure who is underrated because of his online blunders, and his co-chair Andrew Feldman were able to reverse some of the decline, but they were running just to stand still. Some of the biggest increases in membership came in urban centres where the Tories are not in contention to win a seat.

All this made the 2015 election win the triumph of a husk. A party with a membership in long-term and perhaps irreversible decline, which in many seats had no activists at all, delivered crushing defeats to its opponents across England and Wales.

Like José Mourinho’s sides, which, he once boasted, won “without the ball”, the Conservatives won without members. In Cumbria the party had no ground campaign and two paper candidates. But letters written by the Defence Secretary, Michael Fallon, were posted to every household where someone was employed making Trident submarines, warning that their jobs would be under threat under a Labour government. This helped the Tories come close to taking out both Labour MPs, John Woodcock in Barrow and Furness and Jamie Reed in Copeland. It was no small feat: Labour has held Barrow since 1992 and has won Copeland at every election it has fought.

The Tories have become the zombies of British politics: still moving though dead from the neck down. And not only moving, but thriving. One Labour MP in Brighton spotted a baby in a red Babygro and said to me: “There’s our next [Labour] prime minister.” His Conservative counterparts also believe that their rivals are out of power for at least a decade.

Yet there are more threats to the zombie Tories than commonly believed. The European referendum will cause endless trouble for their whips over the coming years. And for all there’s a spring in the Conservative step at the moment, the party has a majority of only 12 in the Commons. Parliamentary defeats could easily become commonplace. But now that Labour has elected Jeremy Corbyn – either a more consensual or a more chaotic leader than his predecessors, depending on your perspective – division within parties will become a feature, rather than a quirk, at Westminster. There will be “splits” aplenty on both sides of the House.

The bigger threat to Tory hegemony is the spending cuts to come, and the still vulnerable state of the British economy. In the last parliament, George Osborne’s cuts fell predominantly on the poorest and those working in the public sector. They were accompanied by an extravagant outlay to affluent retirees. As my colleague Helen Lewis wrote last week, over the next five years, cuts will fall on the sharp-elbowed middle classes, not just the vulnerable. Reductions in tax credits, so popular among voters in the abstract, may prove just as toxic as the poll tax and the abolition of the 10p bottom income-tax rate – both of which were popular until they were actually implemented.

Added to that, the British economy has what the economist Stephen King calls “the Titanic problem”: a surplus of icebergs, a deficit of lifeboats. Many of the levers used by Gordon Brown and Mervyn King in the last recession are not available to David Cameron and the chief of the Bank of England, Mark Carney: debt-funded fiscal stimulus is off the table because the public finances are already in the red. Interest rates are already at rock bottom.

Yet against that grim backdrop, the Conservatives retain the two trump cards that allowed them to win in May: questions about Labour’s economic competence, and the personal allure of David Cameron. The public is still convinced that the cuts are the result of “the mess” left by Labour, however unfair that charge may be. If a second crisis strikes, it could still be the Tories who feel the benefit, if they can convince voters that the poor state of the finances is still the result of New Labour excess rather than Cameroon failure.

As for Cameron, in 2015 it was his lead over Ed Miliband as Britons’ preferred prime minister that helped the Conservatives over the line. This time, it is his withdrawal from politics which could hand the Tories a victory even if the economy tanks or cuts become widely unpopular. He could absorb the hatred for the failures and the U-turns, and then hand over to a fresher face. Nicky Morgan or a Sajid Javid, say, could yet repeat John Major’s trick in 1992, breathing life into a seemingly doomed Conservative project. For Labour, the Tory zombie remains frustratingly lively. 

Stephen Bush is editor of the Staggers, the New Statesman’s political blog.

This article first appeared in the 01 October 2015 issue of the New Statesman, The Tory tide