How Repo Agreements Juiced Securitized-Debt Leverage

All kinds of markets took a drubbing in mid-March as the depth of the economic disruption caused by the pandemic sank in. But what happened in U.S. securitized debt stood out, as the asset class was pummeled by margin calls that forced selling in residential- and commercial-mortgage bonds, collateralized loan obligations and even securities backed by some types of auto loans. New issuance in these markets seized up and stayed frozen for weeks even as other areas of the bond markets, like corporate bonds, roared back to life in response to U.S. Federal Reserve intervention. As the dust has settled, it’s become clear that hedge funds and banks had combined to create far more leverage in structured-credit markets than anyone knew was there.

After years of record low rates, some investors -- particularly hedge funds, structured credit funds and mortgage REITs -- sought to increase their returns by buying securitized debt via so-called repurchase, or repo, agreements with banks, who were their counterparties. This is a type of short-term financing that allowed the funds to amplify their returns on these complex and often illiquid securities. But while leverage brings bigger gains in good times, it can also magnify losses if there’s a downturn.