Lesson 8 of 25 · 7 min

That same bank, 2008: a run on short-term funding

Secured funding vanishes as a decision by counterparties, not as a market price, and it vanishes in days.

Bear Stearns entered March 2008 with a balance sheet reported at around four hundred billion dollars, a large share of it funded in overnight and very short-dated repurchase agreements. Overnight funding is not a loan with a maturity in any useful sense. It is a decision taken afresh every morning by each counterparty, about each piece of collateral.

During the week of 10 March 2008 those decisions changed. Repo counterparties declined to roll, or demanded different collateral; prime brokerage clients moved cash balances elsewhere; dealers stopped agreeing to step into the firm's derivative trades. The liquidity pool was reported to have fallen from roughly eighteen billion dollars to under two billion within days.

Note what did not happen. No court ruled, no regulator suspended anything, and the assets did not have to be worthless for this to occur. A financier declining to renew a secured loan is exercising a term of the agreement. Track 1 lesson 12 makes the same point for individual borrowers: a demand facility can be withdrawn without a default, because withdrawal is not a remedy but a right.

On 14 March 2008 emergency secured funding was arranged through the relevant central bank. On 16 March a sale of the firm was announced at two dollars a share, revised the following week to ten dollars, against a price above one hundred and fifty dollars in 2007. The two funds of the previous lesson had already demonstrated the mechanism at small scale, twelve months earlier.

A rollover market is a queue of daily decisions. It has no maturity to survive to, so it can end in a week without anyone breaching anything.

Key terms

Rollover risk: The risk that short-dated funding is not renewed. It is a risk about other people's choices, not about the value of your assets.
Liquidity pool: The cash and immediately saleable assets held against funding outflows. Its adequacy is judged against a speed of outflow, not a quantity.
Novation: Replacing one party to a derivative with another. When dealers stop accepting novations to a firm, its clients cannot reduce exposure to it, and they leave instead.

Worked example

Two days of a funding run

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. Assets of $4,000,000 funded by $2,960,000 of overnight repo, $780,000 of term debt and $260,000 of equity, with a $300,000 cash buffer.

Day one: 18 percent decline to roll: $532,800 repayable
Cash shortfall on day one: $232,800
Overnight funding remaining: $2,427,200
Day two: 26 percent of the remainder declines: $631,072 repayable
Cash required across two days: $1,163,872
That demand against equity: 4.48x

Fewer than one in four lenders changed their mind and the firm had to convert 29.1 percent of its balance sheet into cash in two days. No asset had to be impaired for this to happen.

Check yourself

A firm funds itself with $1,850,000 of overnight repo and holds a $260,000 cash buffer. One morning, 22 percent of that funding is not renewed. What is the shortfall?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.