Welcome to Finance and Fury, The Say What Wednesday Edition

Question from Mark part 2:

Can you explain the repo markets that are going on at the moment? Apparently the banks are loaning money from the Feds at 10% so they have enough liquidity to survive the night/Bank run?


– Last SWW ep for the year – Taking a break – Monday eps still going but no Wednesday or Friday episodes

Repo market – Or repurchase market – What is it? And why are they done? What this says about the state of the economy

  1. A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities
    1. Agreement where one party sells Gov Bond they own for cash to another party – and promise to buy it back at a higher price in the near future – the inflated value is the repo rate
  2. Active participants in the domestic repo markets are those who deal in Gov Securities – include commercial banks, Central Banks, securities dealers
    1. Securities dealers – typically large domestic and international banks/investment managers that are market makers in domestic government securities –
    2. Investment funds and other non-dealer institutions are also providers of high-quality assets to dealers. These institutions typically use repos to manage their short-term funding while maintaining their exposure to these assets, and in some cases to enhance portfolio returns.
  3. Repo agreements are classified as a money-market instrument – as it functions the same as a short-term, collateral-backed, interest-bearing loan
    1. Buyer acts as a short-term lender, while the seller acts as a short-term borrower
      1. One party needs money – other party wants to make money
      2. It is a sale for cash – a sale of a certain type of fixed interest security
    2. The securities being sold are the collateral – Repurchase agreements are generally considered safe investments – but it does depend on the type of security sold
      1. Most agreements involve U.S. Treasury bonds – also Government Bonds –
      2. Central demand used to mainly be safe assets like these
      3. More recently – MBS, CDOs – assets that aren’t so safe
      4. In the case of bankruptcy, in most cases repo investors can sell their collateral – but not when the assets tank like 2008
  1. Repurchase agreements have a maturity period called the “term” or the “tenor.” – Repos with longer tenors are usually considered higher risk – due to the fact that the longer the tenor – the more factors can affect repurchaser creditworthiness, and interest rate fluctuations are more likely to have an impact on the value of the repurchased asset.
    1. It’s similar to the factors that affect bond interest rates – went through last Weds
    2. The Significance of the Tenor – counterparty credit risk is the primary risk involved in repos i.e. creditor bears the risk that the debtor will be unable to repay the principal – securities as collateralised reduces the total risk – but not by 100%
      1. Specified maturity date (usually the following day or week) are term repurchase agreements – A dealer sells securities to a counterparty with the agreement that he will buy them back at a higher price on a specific date.
        1. The counterparty gets the use of the securities for the term of the transaction, and will earn interest stated as the difference between the initial sale price and the buyback price
      2. An open repurchase agreement (also known as on-demand repo) works the same way as a term repo except that the dealer and the counterparty agree to the transaction without setting the maturity date
        1. The trade can be terminated by either party by giving notice to the other party prior to an agreed-upon daily deadline – automatically rolls over each day and Interest is paid monthly
        2. Nearly all open agreements conclude within one or two years
  2. Repurchase agreements can take place between a variety of parties and reasons
    1. Example – The FED enters into repurchase agreements to regulate the money supply and bank for their reserves.
    2. The most common type is a third-party repo (also known as a tri-party repo)
      1. Repo Arrangement with a middle man – a clearing agent or bank conducts the transactions between the buyer and seller – constitute more than 90% of the repurchase agreement market
      2. Holds the securities and ensures that the seller receives cash at the onset of the agreement and that the buyer transfers funds and delivers the securities at maturation
      3. Two major clearing banks for tri-party repo – JP Morgan Chase and Bank of New York Mellon
    3. Facilitate the goals of both parties – secured funding and liquidity while the other makes a profit
  3. Example – a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also a common tool of central bank open market operations.
    1. In your everyday life – say you don’t have any cash – you job is a delivery driver – but you are out of cash – need money to buy fuel as tank is empty – have a friend come over and buys your TV off you for $100 – and agree that after you finish work you will make $200 – buy TV back for $105 – if deal goes belly up well could sell TV for $100 – here the rate is 5%

The Significance of the Repo Rate

  1. When central banks repurchase securities from private banks – it is done at a discounted rate, known as the repo rate
    1. Repo rates are set by central banks – allows control of the money supply within economies by increasing or decreasing available funds for the repo market – Also affects banks/funds decisions
      1. Decrease in repo rates encourages banks to sell securities back to the government in return for cash – which increases the money supply available to the general economy
      2. Increasing repo rates decreases the incentives – so central banks can effectively decrease the money supply by discouraging banks from reselling these securities
  2. To determine the true costs and benefits of a repurchase agreement – a buyer or seller must consider three different factors:
    1. Cash paid in the initial security sale and 2) the Cash to be paid in the repurchase of the security
      1. Also – The cash paid in the initial security sale and the cash paid in the repurchase will be dependent upon the value and type of security involved in the repo
    2. Third major factor – Implied rate for repo – If the rate is not favourable, a repo agreement may not be the most efficient way of gaining access to short-term cash
      1. But repurchase agreements offer better terms than money market cash lending agreements due to collateral
  3. Risks of Repo – Repurchase agreements are generally seen as credit-risk mitigated instruments
    1. The largest risk in a repo is that the seller may fail to hold up its end of the agreement by not repurchasing the securities
      1. The buyer of the security may then liquidate the security in order to attempt to recover the cash that it paid out initially
      2. Trouble is that the value of the security may have declined since the initial sale – hold and risk more loss, or take loss now
      3. There is a risk for the borrower in this transaction as well – value of the security rises above the agreed-upon terms, the creditor may not sell the security back and abandon agreement

Upcoming Liquidity crisis – The Financial Crisis and the Repo Market

  1. Following the 2008 financial crisis – investors focused on a particular type of repo known as repo 105
    1. Lots of speculation that these repos had played a part in Lehman Brothers’ attempts at hiding its declining financial health leading up to the crisis – where they were entering repo agreements to continue funding operations and to cover losses = created a lack of trust in the system – so the repo market dried up and contracted creating a liquidity squeeze for short term funding
  2. The crisis revealed problems with the repo market in general – bankrupt banks could continue to operate – putting other banks at risk of defaulting when the maturity of the repo occurs – There where and are major systemic risks
    1. The tri-party repo market’s reliance on the intraday credit which the clearing banks provide
    2. A lack of effective plans to help liquidate the collateral when a dealer defaults
    3. A shortage of viable risk management practices
  3. In late 2008 – regulators established new rules to address these risks –
    1. Mainly by putting increased pressure on banks to maintain their safest assets – such as Treasuries
      1. Incentivised to not lend them out through repo agreements
        1. Up through late 2008, the estimated value of global securities loaned in this fashion stood close to $4 trillion – then the figure dropped closer to $2 trillion.
      2. Further, the Fed has increasingly entered into repurchase (or reverse repurchase) agreements as a means of offsetting temporary swings in bank reserves
      3. This IMO created the lack of trust between the participants in repo markets – if Treasuries cant be used as securities – well it is MBS, CDOs and other risky assets up on the table – the very regulations meant to help the system just made it more dangerous due to risks of default and the assets as securities defaulting with it
  4. These changes are ineffective = there remain systemic risks to the repo space
    1. If a default by a major repo dealer occurs – might inspire a fire sale among money funds which could then negatively impact the broader market
    2. Talk about a shift toward a central clearinghouse system – with a new entity run by Central Bankers –
    3. But this was talked about 10 years ago with no real movements towards it – maybe after the next repo collapse
  5. Today – repo is back in full swing – showing signs of an upcoming liquidity crisis. It is as if the Fed’s injection into 23 Wall Street securities firms plus one foreign bank, in addition to buying up $60 billion a month in Treasury bills from Wall Street dealers, has never taken place.
      1. High yielding rates – when trust breaks down or when demand spikes – see spikes in repo rates –
      2. Around the end of quarters and Calendar year (USA especially) due to tax bills due
      3. Saw one in December last year but recently on the 17th September –
      4. This is when the Fed began its Repo loan interventions – because banks no longer trust banks
      5. This form of liquidity crisis is where the economic stresses start to occur due to a lack of money available to fund short term operations
      6. There are some similarities to the liquidity crisis of 1998 and 2008 – when the financial system stops trusting one another and those that need money to stay afloat – can’t find anyone to enter an agreement with them
      7. That is why we have seen some spikes in Repo markets around the world – Europe, China, USA –
        1. Reserve banks are the only ones being the purchaser in repo agreements – so see spikes when massive demands are present
  6. The repo markets operations are the signs that something isn’t right in the financial system – especially after the requirements for banks to hold more Treasury notes – have to sell off riskier assets at higher repo rates


Summary –

No surprise that something isn’t right in the financial system – the spikes in the repo rates are a sign of the liquidity crisis occurring – especially as most managers for investments are almost fully invested – not a lot of cash or reserves in place to fund their own operations without the repo market

Thanks for listening, if you want to get in contact you can do so here: http://financeandfury.com.au/contact/





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