The sharp reduction in financial leverage since the collapse of Lehman Brothers is illustrated by the steep decline in the use of repurchase or repo transactions by Wall Street dealers.
In a repo, an investor can borrow cash for a short period from another party, using securities as collateral for the loan. Investors with large portfolios of securities can thus lend these out and earn a return over time.
Federal Reserve data shows that financing volumes of mortgages, US Treasuries and corporate debt by primary dealers has dropped nearly 50 per cent from levels seen before Lehman's demise. Overall repo activity in the US during the first six months of this year has fallen to levels not seen since 2003.
"Everybody now pays more attention to due diligence and looks at their counter party risk a lot more closely," says Scott Skyrm, senior vicepresident at Newedge, a repo broker dealer.
At the centre of the US repo market sits the tri-party model, where a custodian bank, Bank of New York Mellon and JPMorgan, helps to administer a repo agreement between two parties. An investor places its money with the custodian bank, which in turn lends it to another institution, and then assets are pledged as collateral for the loan.
Such a model functions well when liquid assets such as Treasuries are being used, as this type of collateral can easily be sold.
During the credit boom, which peaked in the first half of 2007, the type of collateral being pledged for cash in repo transactions, had steadily migrated away from Treasuries and towards other assets such as private label mortgages and corporate securities. This reflected the drive by investment banks and investors to boost their leverage and garner higher returns.
"The tri-party repo framework that worked so well for Treasuries was not as robust for less liquid securities," says Lou Crandall, economist at Wrightson Icap. "The system works if the clearing banks are confident that they can liquidate collateral quickly."
The near-failure of Bear Stearns six months before Lehman's demise alerted the Fed to the dangers associated with having two clearing banks supporting the financial system.
Tri-party was very popular with investment banks as it allowed them to finance their balance sheets with short-term funding.
However, as soon as market sentiment turned negative on lower quality or more complex assets, investors who had funded these repo agreements began to pull their money out.
That sparked a run on the investment banks, potentially exposing the clearing banks.
This has left regulators and the market with one big fear: if one clearing bank ran into trouble, could the other step forward and support the system? There is also a separate issue, which is that when investors become worried about a particular institution, any move by a clearing bank to tighten standards could spark a bigger run on the borrower in question that ultimately results in bankruptcy or rescue.
The consequences for the repo market are best highlighted by the plunge in dealers financing corporate securities. A common transaction during the boom involved investors lending out Treasuries and then using the pledged cash to borrow corporate securities. They made money on the difference between the higher rate for corporates than Treasuries.
This daisy chain collapsed when investors lost faith in using corporates as collateral and the relationship between Treasuries and corporate securities changed sharply.
Based on Fed data, corporate securities being financed via repo is currently around $92bn. Last September corporate repo was running at $180bn; it then plunged in the wake of Lehman's bankruptcy and AIG's secured lending problems.
Standards for collateral used in repo remain much higher and traders say reforms for the repo market, which are still being discussed by dealers and the Fed, should focus on making sure that continues.
"Haircuts and margin for repo trades are still significantly higher than what they were before the crisis," says Joseph Abate, money markets strategist at Barclays Capital. "There were a lot of assets that should not have been used as collateral in the repo market to start with. Repo is not a one-size- fits-all market."