Primary Dealers' Behavior During the 2007-08 Crisis

42 Pages Posted: 13 Sep 2017 Last revised: 29 Apr 2018

See all articles by Rajkamal Iyer

Rajkamal Iyer

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Marco Macchiavelli

Board of Governors of the Federal Reserve System

Date Written: December 13, 2017

Abstract

We shed light on the behavior of the U.S. Primary Dealers during the 2007-08 financial crisis. First, we show that dealers’ exposure to risky assets drives the observed repo funding squeeze; moreover, only during times of stress, repos become sensitive to counterparty risk, which is exactly what they are designed to avoid. Second, we identify vulnerabilities in the way what repos are used, namely to finance dealers’ net positions (inventories), or to intermediate securities for their clients, often through ``matched-book” trades. In the latter case, the collateral obtained through a reverse repo is financed with an associated repo. We show that most of the deleveraging following the repo squeeze happens by unwinding matched-book trades (closing reverse repos), and only partly by selling illiquid inventories at fire-sale prices. Finally, we document the systemic nature of settlement fails: at the dealer level, failure to receive a security is passed 1-to-1 into a failure to deliver the security, making fails systemic events.

Keywords: Financial Intermediation, Primary Dealers, Financial Crisis, Repo

JEL Classification: G01, G10, G20

Suggested Citation

Iyer, Rajkamal and Macchiavelli, Marco, Primary Dealers' Behavior During the 2007-08 Crisis (December 13, 2017). Fifth Annual Conference on Financial Market Regulation. Available at SSRN: https://ssrn.com/abstract=3035472

Rajkamal Iyer

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

Marco Macchiavelli (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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