Bruno Behrend wrote a layman’s view of the Repo Market. As he noted,
…the entire US (and international) financial system is so laden with funny money (essentially un-quantifyable assets), that even after billions have been written down, no one is willing to price them.
This “plain vanilla” repo market, that is “decades old” is so full of rotten apples (CDOs and synthetic CDOs), that the Fed couldn’t allow the market to price it. Too many institutions would have been exposed as holding essentially worthless assets.
We had a brief e-mail exchange, in which I included the following vague:
1. The difference between the transparent products and the opaque ones is a bit more risk of failure, but if the failure does occur, it will be years later.
2. Because they got a bit more of a margin on the opaque instruments (remember – any failures would happen years in the future), the banks stared issuing more of these opaque instruments.
3. Over time, everyone got used to them. And they couldn’t be so bad – after all, so far nobody lost money on them, right? (That’s 2004, 2005, 2006).
4. So the market grew and grew, and after a while, because the process went on and on and nobody lost money on those instruments, they became, as far as everyone was concerned, no more risky than plain vanilla.
5. If you have the choice between two flavors of vanilla, you go with the one (opaque) that has the higher pay-ff.
6. The future arrived.
It occurs to me this is the timeline that exists with many financial meltdowns. To a large extent, it explains how South American countries fell heavily in debt in the last century. It explains how large (mostly American) banks got in trouble for lending money to South American countries. To some extent, it explains the S&L and junk bond fiasco, and the dotcom bubble.