Financial Risk Manager Part 1
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Q.422 The main vulnerability of the repo market in the time period leading up to the financial crisis had much to do with the fact that:
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A
The market was highly susceptible to fluctuations in foreign exchange rates, which created additional risk for international institutional investors.
B
The market was large and unregulated, and many repo agreements were backed by securitized mortgages as collateral.
C
The market was dominated by a small number of large financial institutions, creating a lack of competition and skewed pricing dynamics.
D
Most repo agreements were tied to specific equity indices, creating a direct link between the stock market's performance and the stability of the repo market.
Explanation:
The repo market was indeed large and unregulated, and many repo agreements were backed by securitized mortgages as collateral. Repo agreements are transactions where a large-scale depositor or institutional investor puts money in a bank for a short term, usually overnight. The bank agrees to some "overnight interest" on the deposited amount. The deposit is secured by an asset of roughly the same value. Between 2000 and 2007, the repo market accounted for up to 30% of the U.S. GDP. Despite the large scale of such transactions, the market was largely unregulated, making liabilities among dealers and brokers grow sharply. A popular view is that the repo market collapsed when cash depositors became concerned about the quality of the collateral (securitized mortgages) backing their deposits.
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