If I buy a bond to sell it back to you tomorrow morning at a profit, am I borrowing the bond, or am I lending the money? . . . And doesn’t this all unravel by 8am, so what’s the point?
Arnold owns a bond. Arnold wants to finance that bond with (very) short-term money. Daniel lends Arnold money, with the bond as collateral. The mechanics of this are that Daniel takes possession of the bond until Arnold repays the loan. Daniel does this by buying the bond today with an agreement that Arnold will buy it back tomorrow. It could be said that Daniel borrows the bond and lends money, while Arnold borrows the money and lends the bond. But I prefer to think of it as Daniel lending to Arnold with the bond as collateral.
It may seem silly to do this just for one day. But (a) these agreements often get renewed and (b) both parties are better off. Arnold’s bond typically is accruing interest at a higher rate than what he pays, so he is earning a spread while he carries the bond in inventory. Meanwhile, Daniel, who has excess funds on hand for a few days (think of a corporate Treasurer with funds that came in from goods sold Monday but who will need to pay suppliers on Wednesday in order to restock) gets to earn some interest without making a long-term commitment of funds and with essentially zero risk.
The repo market works smoothly when the bonds are widely viewed as having no risk. In 2008, some mortgage securities became perceived as high risk, and the repo market for them dried up. Gary Gorton and Andrew Metrick called this a run on repo. Until they wrote the paper, 99.9 percent of academic economists had no idea what repo even was. There was, and still is, a huge gap between practitioners’ knowledge and academic understanding. Tim Taylor’s original post speaks to that.
“Daniel does this by buying the bond today with an agreement that Arnold will buy it back tomorrow. It could be said that Daniel borrows the bond and lends money, while Arnold borrows the money and lends the bond. But I prefer to think of it as Daniel lending to Arnold with the bond as collateral.”
You can think of it however you prefer, but a lawyer will tell you that legally the consequences of the three different transactions you describe are quite different.
Arnold has provided, in the last two days, the the most admirably concise and lucid explanation of repo that I have ever seen. But Jon (and Handle below) make good points about the legal implications that Arnold did not get to in such a brief introduction to the subject. I hope Arnold will comment further on this aspect.
Because the lender in repo really does, however briefly, purchase and own the bonds, his collateral is fully protected against a bankruptcy by the borrower. Is this a good thing? Well, as always, there are trade offs.
When the system works well (and it usually does) it results in a lot more efficiency and prosperity in the economy than there would be without it. When it works poorly, some of the most reckless lenders suffer the least from lending to bad credit risks. There is moral hazard.
One way to think about repo is that it is like FDIC insurance for institutions too large for effective FDIC insurance. So then FDIC insurance works well most of the time but the downside is that it makes it possible for the least responsible banks to raise money they wouldn’t be able to raise without it by off loading the risk to someone else.
The ironic thing is that I’d guess that almost all the poorer half of Americans know perfectly well what pawning and repossession entail.
If I pawn a ring, you give me some quick cash as a loan, but you hold on to the ring, as collateral.
If I want it back, I have to give you the cash back, with interest.
A repo is just a pawn without the uncertainty, that is, with an extra agreement to redeem the ring, at a particular price and time.
You could just call it “Overnight Pawn”.
You can do this with bonds too, and what makes that special is that the bonds keep collecting interest at the bond rate which is usually different from the loan rate.
There is a very busy market in overnight pawns for government bonds, and the Federal Reserve plays on both sides of that market to accomplish its goals.
Until they wrote the paper, 99.9 percent of academic economists had no idea what repo even was.
Many of them became experts on the topic seemingly over night, though, after 2009. Or at least, they pretended to be.
It was repos that caused the collapse of the state run deposit insurance fund in Ohio back in ’84 or 85. An investment firm (IIRC, run by the son-in-law of a guy that was an Ambassador during the Carter Administration) used repos with state-chartered S&L’s and banks (and I think the city of Toledo) but the institutions investing in the repos didn’t receive the treasury securities as collateral and the investment firm created more repos than it had bonds. Then of course, the scoundrel couldn’t (or didn’t) repurchase the bonds, the financial institutions collapsed, and the state-run deposit insurance fund ran out of money. Ohio’s governor was forced to declare a bank holiday to stop a run on the state chartered institutions. These institutions then had to either qualify for FDIC insurance or be acquired by other financial institutions.
My understanding is that a lot of these repo actions are happening simultaneously, where Arnold has no money and no bonds so he goes on the repo market to finance a bond purchase. He finds an acceptable bond for sale and finds someone willing to lend against a bond and makes both transactions using the borrowed money to buy the very collateral he wants.
Money market funds esp. use repos frequently for liquidity purposes. See this explanation, which is just the top result that I turned up in a goog. search:
http://www.citibank.com/transactionservices/home/oli/files/wells_fargo_repos.pdf
I may be wrong, but I believe that, since mutual funds only calculate final net portfolio values at the close of each trading day, it’s only at that time that they accurately know their liquidity position and/or needs for the purpose of fulfilling cash redemptions & calculating their federally-required liquidity minimums.
Repo market 85% of money supply.
Fed Reserve 15%
Why inflation hasn’t taken hold and massive deflation/collapse is biggest risk. Fed (FDIC) will lockdown bank accounts after a bank runs, giving us a debit card that will Expire in x days
“Money supply” ??? M1? M2? Other financial instruments?
Gold?
Bitcoin? / crypto?
“Experts” don’t even agree on what “Money supply” means.
Getting a Fed debit card seems like a likely step coming.
With a new $1.9 trillion COVID bill money supply increase, are you claiming to expect some $1.6 trillion increase in Repo market? I don’t believe this.
So I don’t understand the 85/15 percentages; but it’s an interesting question.
I have been responsible for risk management of repos at one of the largest global market participants since before the 2008 crisis. This is an excellent summary. Legally it’s a sale and buy-back, but economically it’s a loan. It can be both things. A crucial point for banks is that it’s very capital-efficient. Regulatory capital is calculated on basis of volatility over a five-day period, which is the maximum close-out time after default. Derivatives need ten days or more, and secured loans longer still. The legal form of repo can be used on any collateral. The market is overwhelmingly highly liquid bond, mainly sovereigns. But there’s also a market in ‘risky’ bonds with bigger haircuts. #AskMeAnything if you’d like practitioner details.
Until they wrote the paper, 99.9 percent of academic economists had no idea what repo even was.
This is HUGE, and a great reason to not believe most academic economists. Specialization and Trade arguments are much better explanations – but don’t quite so easily translate into policy recommendations.