Repo Markets Won't Kill The Economy

by: Rodney Johnson

Summary

In the finance world of our economy and markets, repos are agreements to complete a transaction that will be reversed a day or a week later.

But there’s a problem in the repo market, or at least in the U.S. Treasury repo market. That is: There aren’t enough bonds to go around.

The good news for those of us away from the market, this particular circumstance doesn’t look like it can blow up in our face anytime soon.

In the finance world of our economy and markets, repos are agreements to complete a transaction that will be reversed a day or a week later.

When talking about repos, Emilio Estevez comes to mind. He will forever be the Repo Man (1984) - a guy who repossesses cars for a living.

The vehicle (no pun intended) for the movie is a Chevy Malibu with radioactive alien bodies in the trunk, that instantly kills anyone who opens it.

The movie is funny, clever, and enough of a campy film to be thoroughly enjoyable. (For those who like trivia, I've added a bonus to the end of this article).

These are all qualities that are completely lacking in the real "repo men" and the repo industry of Wall Street. But while the repo market is devoid of anything cool, there are some who think it could still prove to be radioactively toxic to the economy, much like it was in 2008.

I give that about zero chance of happening. (But trading or funding debt in our economy and markets, that's a different story).

For those who might be confused, thinking Wall Street bankers are busy repossessing each other's Ferraris, that's not what I'm talking about.

Repo Markets Involves Institutions

An insurance company or money market fund, for example, that owns securities and has a short-term need for cash. The institution will sell a security, such as a 10-year Treasury bond, to another company, with the agreement that the security will be sold back, or repo'd, in a day or a week at an agreed-upon price.

This sort of thing happens a lot. In fact, the daily borrowing and lending of securities now represents about $1.6 trillion.

But there's a problem in the repo market, or at least in the U.S. Treasury repo market. That is: There aren't enough bonds to go around.

Sometimes institutional investors who think bond prices are going to fall will sell bonds they don't own (selling short), which means they have to borrow the bonds from somewhere else.

If they're unable to borrow and deliver what they previously sold short, they've "failed to deliver," or simply "failed." Failure to deliver is a common occurrence in the securities markets, but it's usually not a big part of daily transactions.

What makes the current situation in the repo market worse than usual is the fact that the Federal Reserve has purchased so many bonds. With severely limited supply remaining for trading and pledging as collateral, from time to time market participants fail to deliver at a much greater rate than before.

In 2012, weekly fails ran around $48 billion. That might sound like a lot, but it's only about 0.6% of the weekly value of transactions.

However, in some weeks the fails can explode. Near a U.S. Treasury auction or a Fed meeting, fails can quickly ramp up. This is exactly what happened the week of June 12 of this year, when fails popped to $163 billion.

This can have really bad consequences, and failure to deliver did cause shocks to the financial system from 2007 to mid-2009. But then the rules changed, so now there really isn't much of consequence for failing in this repo market.

In the weird world of securities, the lending rate can go negative if they're in high demand. Given that bonds have a rate of interest, a buyer who provides cash can usually earn interest by purchasing a bond, even if it's for a day.

However, if the bond is in short supply, the seller can demand that the buyer sell it back at a lower price, which means the buyer actually earns a negative rate of interest.

In May of 2009, the Federal Reserve set a limit on the penalty rate paid by those who fail to deliver securities in the repo market. That rate is 3%, which means that anyone and everyone can fail to deliver, and all they will suffer is a 3% penalty interest rate. With their losses capped, institutions can rest easy that a problem finding securities in the repo market won't crash their business, even if it does cost them some cash.

It might be a strange business practice to enter into a transaction knowing you can't deliver, but hey, this is Wall Street.

The good news for those of us away from the market, this particular circumstance doesn't look like it can blow up in our face anytime soon.

P.S. For the trivia buffs, as promised - Repo Man was directed by Michael Nesmith, who was one in the cast of The Monkees. Mr. Nesmith's mother was a typist in Dallas, where she invented a corrective liquid that she called Liquid Paper. She sold it to Gillette for $48 million. Who knew?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.