Repurchase Agreements (Repos)
Repurchase agreements are short-term collateralized loans used by major financial institutions to obtain short-term funding by pledging their assets for short-term loans or to earn interest by lending cash collateralized by those assets. Central banks uses these agreements to provide credit for major financial institutions and to manage interest rates.
Repurchase agreements (aka repos, sale-repurchase agreements, reversing out, to repo securities, to sell collateral, RPs, buybacks) are agreements between a borrower and a lender where the borrower, in effect, sells securities to the lender with the stipulation that the securities will be repurchased on a specified date and at a specified, higher price. The securities serve as collateral for the loan. The difference between the repurchase price and the amount loaned is the amount of interest paid by the borrower to the lender, which is found by the following formula (repo formulas use a banker's year of 360 days):
Dollar Interest = Principal × Repo Rate × (Repo Term in days/360 days)
The repo rate is the annualized interest rate of the transaction:
Repo Rate = Dollar Interest/Principal × 360/(Repo Term in days)
The repo rate typically ranges from 10 to 200 basis points less than the Fed funds rate. The Fed funds rate is higher because Fed loans are unsecured. Sometimes margin must be posted, where the amount of the loan is slightly less than the worth of the collateralized securities, also known as a haircut. This helps to protect the lender from the possibility that rising interest rates will reduce the value of the collateral. Most repo agreements mark the collateral to market daily. If the value of the collateral drops below the required margin, then the borrower may be subject to a margin call, or the repo may be repriced in which the value of the loan is reduced. In either case, the borrower must send more money to the lender to maintain margin or to reduce the principal outstanding.
The main benefit of repos to borrowers is that the repo rate is less than borrowing from a bank. The main benefit to lenders over other money market instruments, such as commercial paper, is that the maturity of the repo can be precisely tailored to the lender's needs.
Major borrowers include government bond dealers of Treasuries and federal agency securities, large banks, and also dealers in bankers acceptances, CDs, and Euros. Government securities are the main collateral for most repos, along with federal agency securities, mortgage-backed securities, and other money market instruments.
Overnight repos are 1 day loans; term repos have terms of greater than 1 day—usually weeks to months.
The firm that makes the loan for a repo, usually a bank, has a reverse repo position (aka reverse, reversing in, to do repo, to buy collateral), which is simply the opposite side of a repo. Hence, for every repo, some party has the reverse repo.
An open repo (aka open-maturity repo) is a contractual relationship that allows the borrower to borrow funds up to a certain limit, without signing a new contract—somewhat like an open credit arrangement. An open repo reduces settlement costs if the repo must be rolled over. However, each party has the right to cancel at any time. Open repos also gives the dealer the right of substitution, which allows the substitution of other securities of similar credit quality for the collateral. The interest rate on open repos is slightly higher than on overnight repos.
One of the problems and costs of repos is the delivery of collateral. If the lender doesn't take possession of the collateral, then the borrower could borrow more funds using the same collateral, increasing the credit risk for the lender. So the lender must take possession to protect its interests, an added cost that the borrower must pay. However, for overnight repos, physical delivery would be virtually impossible. In these cases, the borrower can set up a custodial account for the lender at a clearing bank. While the loan is outstanding, the securities are held in the custodial account for the benefit of the lender. When the repo is repaid, then the clearing bank can move the collateral back to the borrower, or to another account for a repo with another lender. Since the collateral can be moved by simply adjusting the beneficial owner in the electronic record of the collateral, the delivery is fast and cheap.
Purpose of Repos
The main purpose of repos is to finance the purchase of securities by government bond dealers until they can be sold to customers. These are private trades for which there are no public quotes. For instance, since the United States Treasury sells its securities by auction, dealers must bid by specifying the price and quantity, and pay for successful bids by the settlement date. However, the dealer may not have all the money on the settlement date, so if a dealer successfully bids for $1 billion worth of Treasuries, the dealer may pay $100,000,000 on the settlement date and finance the rest from the Treasury with the stipulation that they will be repurchased after the dealer receives payment from his customers. As the dealer sells more securities, more of the collateral is repurchased from the Treasury for the bid price plus accrued interest on the security plus the interest that the Treasury charges for carrying the inventory. Because most dealers can sell most of their inventory quickly, they only need to borrow money for a day or a few days at most, which is why the terms of most repos is very short.
The Repo Market
The repo market in the United States began in 1917, and expanded substantially in the 1980s. The Federal Reserve, as well as other central banks, use repo markets to extend credit and manage interest rates. Money market funds use repos to earn interest. The repo market is the largest money market sector. There are several other large traders of repos besides government bond dealers. The net buyers of repos are money market funds, bank trust departments, municipalities, and corporations. The net sellers of collateral are thrifts and commercial banks.
Repos are not only used to finance inventory, but are also used to cover short positions of securities, and much of the repo market arises from speculative trading, where traders attempt to profit from the differences in the repo rates of repos and reverses. However, probably the largest player in the repo market is the Federal Reserve.
While the Federal Reserve can, and does, implement monetary policy by buying and selling Treasuries outright, its major tool is repos—buying collateral increases the amount of money in the market and lowers interest rates, and selling collateral has the opposite effect.
The Fed uses different terms to describe repos and reverse repos. A system repo is when the Fed lends money to dealers based on their collateral. Hence, the Fed is describing its reverse repo in terms of the other party's view (evidently referring to the parties in general as the system) rather than its own. Similarly, a customer repo is a system repo that the Fed carries out on behalf of a foreign central bank. When the Fed borrows money by selling collateral, it is called a matched sale repurchase agreement, which is usually shortened to just matched sale.
During December, 2009, the Fed had started testing the use of reverse repos for withdrawing money out of the market. During the credit crisis, the Fed bought large amounts of mortgaged-backed securities (MBSs) as a way to keep interest rates low and to increase the money supply to stimulate the economy. However, it was always the Fed's intention to reverse this supply of money to minimize inflation. The Fed could simply sell the mortgaged-backed securities to decrease the money supply, but if it did so, the price of the MBSs would fall, which would increase mortgage rates, which would dampen the housing recovery. The reverse repo solves this problem by reducing the money supply through short-term trades rather than by selling. Since the Fed buys back the MBSs at a stipulated price, MBS prices don't fall and mortgage rates don't rise, but the continual rollover of the reverse repos does reduce the money supply. (Fed Begins Testing a Strategy to Exit a Securities Program)
Repo Rate Determinants
The repo rate, which is the interest rate that the lender charges the borrower, will always be less than the Federal funds rate, since the latter has no collateral backing it. The Federal funds rate and the yield curve partially circumscribe repo rates.
The repo rate for a particular transaction depends on the following factors:
- Credit quality: like most other securities, the interest rate varies inversely with the credit quality of the issuer—the higher the credit quality, the lower the repo rate.
- Liquidity: greater liquidity lowers trading costs and, therefore, the repo rate.
- Delivery: if the collateral must be physically delivered, the lender will charge a higher repo rate to cover its cost.
- Collateral availability: if the collateral is a special issue that is hard to get, the seller of the collateral will be able to obtain a lower repo rate from a lender that needs the collateral.
Haircuts, Collateral Quality, and the Credit Crisis
The haircut of a repo depends on the quality of the collateral. If there is a risk that the value of the collateral will decline over the term of the repo, then the lender will require a larger haircut. Banks are a major user of repos because they provide liquidity. However, during the 2007-2009 credit crisis, the perceived credit quality of asset-backed securities, especially mortgage-backed securities, declined, causing lenders to demand much more of a spread between the value of the collateral and the loan amount. This, in turn, forced banks to keep more cash, with the net result that many banks lowered the amount of their lending, which lowered the money supply in the economy, thereby lowering economic output and increasing unemployment.
Since interest rates on short-term money market instruments change daily, repos can also be used to profit from speculations about future interest rates by, hopefully, borrowing low and lending high, as long as the differential is great enough to cover trading costs. For instance, if a speculator thought that interest rates were going to rise over the next several months, she could borrow money from a repo with a term of 90 days, then do overnight reverses with the money. If her prediction is correct, then she can lend at successively higher interest rates while paying the locked-in lower rate on her 90-day repo. If her prediction is wrong, then she will still have to do the reverse repos, so that she can earn whatever interest she can, but it will be less than what she is paying—hence, she will suffer a loss.
If a speculator thought that interest rates will be going down over the next several months, then he would do a reverse term repo by lending the money which he got from an overnight repo for a term of 90 days, let's say, then continue borrowing the money through overnight repos to pay back the overnight repo that is maturing—in effect, rolling over the debt at successively lower interest rates while getting a higher interest rate for his reverse. If the speculator bet wrong, then he would have to pay more in interest than he would earn.
Sometimes the losses can be huge. For instance, in 1994, the municipality of Orange County, California lost $1.5 billion dollars in speculative trades that involved repos, eventually forcing it to declare Chapter 9 bankruptcy—the largest municipal bankruptcy ever. Prices of all municipal bonds dropped dramatically as the Orange County fiasco underscored the fact that municipal bonds may not be as safe as had been supposed. On December 7 of the same year, the state of Texas lost $70 million from their state investment pool trading speculatively in repos and reverse repos.
A dealer firm can sometimes profit from the credit spread of a matched book, which is a repo and reverse repo of the same maturity.
Some trades in the repo market are done to cover short positions. When a dealer shorts securities, it may try to temporarily replace those securities with a repo. It will first look to its customers to see if any of them will do a reverse using the shorted security. If that is not possible, then the dealer will use the services of a repo broker, especially if the securities are difficult to acquire—called a hot issue (aka special issue). Of course, the repo can only replace the securities temporarily. Eventually, the dealer will have to buy the securities to replace those that were sold short — hopefully at a lower price.
The Bankruptcy of Orange County
Robert Citron was a treasurer and tax collector for Orange County, California for many years. When Citron started in 1971, as the tax collector and later as the county treasurer, interest rates rose steadily, so all that he had to do to earn a high return on the county's investment pool was to buy government bonds. But interest rates had peaked in the early 1980s, then steadily declined thereafter. Citron predicted that interest rates would decline for a while, so he developed a new investment strategy where profits were earned from the interest rate spread between long-term government bonds and the short-term repo rate. In the early 1990s, using this strategy, he earned high returns on the investment pool that covered about 189 different public entities in Orange County, including 31 cities, local school districts, and water and sanitation authorities. Based on this success, he was named as 1 of the top 5 financial officers by City and State magazine in 1988. (Citron also used inverse floaters, where interest payments increase when interest rates decrease, and vice versa. However, since this article is about repos, we will focus on how he used these financial instruments to increase returns.) He would buy long-term, safe government bonds, then enter into repo agreements with several banks, using the long-term government bonds as collateral, which had higher interest rates than the repos. Even though the long-term government bonds were collateralized, Orange County continued to receive the interest payments from those bonds. This allowed Citron to buy even more long-term bonds to enter into more repos, thereby increasing his leverage, using an initial $7.6 billion to buy $20.6 billion of investments.
Although repos are very short-term, Citron used open repos, whose term continued until either party terminated the transaction. This investment strategy worked as long as interest rates either stayed the same or decreased, but in early 1994, the Fed started raising interest rates. As the Fed continued to raise interest rates, the spread between the long-term bond rate and the repo rate diminished. Eventually, the repo rate actually exceeded the long-term bond rate, causing big losses.
Moreover, because bond prices are inversely related to interest rates, the higher interest rates caused the value of the long-term bonds to decline, so the value of the collateral held by the banks also declined.
In a repo transaction, the banks holding long-term bonds as collateral have the right to liquidate the bonds in the event of nonpayment, without going to court, even if the borrower declares bankruptcy, so the banks liquidated the bonds, forcing Orange County to recognize a loss of more than $1.64 billion on $11 billion worth of bonds. Considering that the Orange County investment pool held $7.6 billion before incurring losses, that is a more than 21% loss. Of course, the step-up double inverse floaters, whose interest payments fell twice as fast as interest rates rose didn't help either. Thus, Orange County, 1 of the richest counties in the United States and 1 of the few Republican bastions in California, was forced to file for bankruptcy on December 6, 1994, the largest municipal bankruptcy up until that time. The final bankruptcy payment will be made in 2019. During this period, bankruptcy payments averaged $68 million per year, money that could have been used to pay for municipal services. As a result of this financial fiasco, public treasurers, at least in California, are no longer permitted to use leveraged investments with tax money, are no longer permitted to use exotic investments, and must mark to market the worth of their holdings, meaning that the value of the investments must be reported periodically.
Ironically, John Moorlach ran against Citron in 1994, warning the taxpayers of the coming fiasco, but public officials reprimanded him for worrying investors, dubbing him "Chicken Little". When the county was finally forced to declare bankruptcy, Moorlach was appointed Treasurer Tax Collector, and he got a special license plate commemorating his prediction: "SKY FELL".