Everyone who has followed this website since 2009 will know that we firmly believe that the “magic plumbing” of the modern financial system is not what is seen on the surface, in terms of declared “on the books” assets and liabilities, but what happens beneath it – in the shadow banking system, a place where trillions in liabilities are created and destroyed via the repo market, to provide short-term funding for all sorts of financial intermediaries, frequently with zero actual exposure in bank Ks and Qs due to regulatory loopholes that allow the “netting” of hundreds of billions of offsetting repo exposure and keeping them off the books, exposure which than can be rehypothecated countless numbers of times. In theory, this works fine. In practice, when a collateral chain is broken and net suddenly becomes gross, you end up with near systemic collapse (especially when the underlying collateral is found to have never existed in the first place – see China).
This is precisely what happened following the failure of Lehman when in addition to all other credit risks, maturity, credit and liquidity, one also had to add counterparty risk. Suddenly, the realization that any and every bank can fail caused a sudden and epic rush on repo, in the process truncating collateral chains and smashing the velocity of collateral. This is also why the Fed had to step in and take over virtually the entire financial system: after all the Fed can’t fail, or so the conventional wisdom goes. And with this backstop in place, the US financial system has been moving slowly since 2009, as counterparty risk has never been mitigated, In fact, for all its confusion, the Fed doesn’t realize that because it has onboarded countarparty risk exposure as one of its primary functions, there is no hope that a return to normalcy will ever be achieved. In brief: counterparty risk – one where the overnight funding market may freeze up at any given moment in a world without the Fed – is now a staple of the financial system. It also explains why the Fed will never be able to exit the market, as the second it does there will be sweeping repo runs of the kind that crushed Lehman and the money market system in 2008.
