A repurchase agreement (repo) is a thing most investors have paid little attention to before September 2019. Repo market is supposed to be boring but its current state concerns many investors and it could affect the economy in a big way.
In this article, I’ll explain what is repo agreement, how it works, and why every investor who values macroeconomic data should keep an eye on the state of the repo market.
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Repo, or repurchase agreement is a special type of financial contract that powers the short-term credit market. It involves at least two parties:
- Borrower (also known as cash receiver)
- Lender (also known as cash provider)
Borrowers use repo contracts as a relatively cheap way to get cash and lenders like the fact that repos are almost risk-free because the borrowers have to back their loans with a sound collateral such as government bonds. This kind of arrangement allows lenders to earn some interest on their cash without taking a significant risk.
Let’s say there is a health insurance company that faces a sudden spike in insurance claims due to an outbreak of some nasty viral disease which is also quite expensive to cure. The company has enough money in total assets but it doesn’t have enough cash.
The thing is, this company is well managed and it owns a diversified set of government and corporate bonds and the only problem is that the hospitals aren’t interested in bonds: they want cash and they aren’t ready to wait till all of those bonds mature. It looks like there is an urgent need to get cash in order to pay those hospitals. What’s the best way to do that?
The insurance company can sell some of its bond holdings but bonds aren’t as liquid as cash and it’s not always easy to sell a lot of bonds in a short period of time because any significant spike in supply would drive the price of those bonds down and good money managers don’t like to sell low.
A repurchase agreement is a way to swap less liquid assets for cash - the most liquid of all assets, without executing a sell order. It’s a good option when a company needs to get some cash for a short time but doesn’t really want to sell any assets in the long run. Companies can get a lot of cash this way, as long as they have enough collateral. The Repo market is basically a pawnshop for business.
Are Repos Safe?
The amount of risk for the lender depends on the quality of the collateral. Most repo contracts are backed by government bonds and they’re considered safe as long as they’re nominated in the official currency of the issuer country. Central banks can often print their way out of trouble so it’s unlikely that the United States will ever default on USD-nominated bonds as long as it has enough paper.
Repo agreements are most often used for short term borrowing so the risk of inflation is also low. Those two factors make repurchase agreements look attractive for anyone who has some spare cash and who also has a low-risk tolerance. The most common example of such an entity is a money market fund. Those funds are legally obliged not to buy anything risky so they’re ready to supply a lot of cash for a relatively modest rate of return.
Federal Reserve and Banks
Banks often need cash, even when they’re in a good financial shape.
Being illiquid isn’t as bad as being insolvent, after all. So, let’s say a wealthy client wants to withdraw a huge deposit from a certain bank. This bank is perfectly solvent but it doesn’t have enough cash to fulfill such a request. Sounds dangerous, is there a way out?
As with the previous example, the repo market can come to the rescue. It’s a good source of cheap cash so the bank from our example can go there and get some cash, right? It turns out, many US banks and other repo market participants are now dependent on the Federal Reserve instead of the free market. For some reason, the free market doesn’t agree with the Fed on how much should lenders charge for their cash.
First, let’s define what is “cheap” when it comes to the interest rates on the short term repo loans. The borrowers used to pay around 1.7% a year for such a privilege but on September 16, 2019, the repo rate jumped to 10%. This is a dangerous situation because many borrowers may not be able to pay such an interest and it also means that the Fed lost control over the short term lending rates.
The Fed didn’t like it at all and the central bankers decided to intervene as fast as possible.
By “intervention”, they meant “buying repos like crazy” so it’s the kind of a measure that is aimed to “fix” the market. No wonder the Fed told the public that such a spike was due to an unfortunate combination of “technical factors” and it won’t last long.
This looks very suspicious. Just think about it: one day a lot of banks are ready to lend cash for 1.7% a year and the next day banks are hesitant to lend for 10% a year? It doesn’t make any sense and people started to ask banks why didn’t they want to grab all of that money?
Jamie Dimon, CEO of JPMorgan Chase, one of the biggest US banks, said that he saw a profit opportunity in the repo market and he wanted to act but his hands were tied by a set of government regulations that the US banks have to follow. He also believes that other banks were in the same position so they were too afraid of the government to act in their best interest.
The World is Addicted to Cheap Money
Everyone is talking about COVID-19 now and there are many ways in which it affects our health and wallets but we shouldn’t forget that we weren’t in the best economic shape even before the pandemic. It’s safe to say that our economy is fragile and we don’t have enough macroeconomic ammunition to deal with a big downturn. The conventional remedy is to lower the price of money and hope it’ll stimulate the economy but the interest rates are already close to zero across the world so there are no conventional and politically feasible ways to get out of trouble.
The world’s most developed nations have increased their debt burden during a spending spree in the aftermath of the Great Recession. Having a lot of debt is not a big problem as long as the borrowing costs are close to zero but it also means that any upward movement in the price of money will cause a terrible withdrawal so the central banks keep injecting more and more debt and do everything they can to suppress the borrowing costs. What would happen if we try to get back to normal and deleverage the economy? Well, it certainly looks like the Fed doesn’t want to find out.
The repo market is a good source of cheap money until it’s not. September 2019 isn’t the first time when repo costs suddenly spiked. It also happened during the Great Recession and it harmed many market participants in a big way.
Repurchase agreements are a great tool that fuels the short-term debt market but it can also introduce certain risks if both parties aren’t careful:
- Lenders should keep an eye on the quality of the collateral, especially when things aren’t that great in the economy.
- Borrowers are exposed to sudden rate spikes so it makes sense not to get too dependent on low-interest rates.
Repo rate spike is a sign of trouble and the state of the debt market is probably one of the biggest macro issues at the moment.