For most of us, the word repo is short for repossessed and it isn’t generally a good thing.
Any sort of loan collateral can be involved, but automobiles are the most familiar — both in reality and in our imaginations. Cars taken by repo men are a staple of movie and television scripts, as are the confrontations which sometimes result when we don’t keep up with the payments.
The repo market in financial centers, including Wall Street, means something else entirely — although collateral is involved. It is a process that was quietly created by the Federal Reserve about 90 years ago as a way to add or subtract cash to the banking system as necessary to regulate the money supply without disrupting the market.
At its heart, the repo market allows the Fed to achieve its money supply and liquidity goals by letting banks adjust their own liquidity positions. It is more effective when smaller, steering changes are in order, but its power shouldn’t be underestimated. There have been extended periods when the Fed has used the repo market virtually as its only monetary policy tool.
Repo in financial markets does not refer to repossession but to repurchase. Essentially, the repo market is made up of sale-and-repurchase agreements. One bank, for example, contracts with another to sell, say, a million dollars worth of Treasury bills, and agrees to buy them back the next day.
Even though it is technically and legally a sale, the transaction is treated much as if the selling bank is borrowing a million dollars overnight from the buying bank. In the market itself, the Treasury bills are known as the collateral, and the contract itself is valued using an interest rate just as if it were a loan. Using interest rates and loan terminology provides a kind of common denominator which allows repo market transactions to stand comparison with other kinds of instruments and transactions in an increasingly complex market. This opens up the repo market to all kinds of investors, not just banks adjusting and rebalancing their liquidity-return equations.
Over time, the ever-increasing volume of U.S. Treasury bonds, notes, and bills floating in the market, along with the increasing operational ease for market participants — banks, corporate treasurers, governments, and private investors — has fostered a huge repo market. There is no official data on its size, but it was fast approaching $3 trillion in 2008. And then suddenly it wasn’t. The credit crunch nearly shut it down.
Most people had believed that the repo market was the most secure and perhaps the least vulnerable to waves of anxiety and fear over safety and credit risk. After all, each transaction was backed by U.S. government securities or some other blue-ribbon collateral.
Probably the largest repo market in the world is New York City’s tri-party repo market operated by two banks: the Bank of New York Mellon and JPMorgan Chase. These two banks are the third party to the buyers and sellers in repo transactions, and are compensated for doing the record-keeping and holding the collateral for the participants. It is a large market, accounting for as much as $2.8 trillion in securities bought and sold during its peak trading time in 2008.
This market froze up in the financial crunch, though, and in doing so probably made things worse. The Federal Reserve Bank of New York, through its Payments Risk Committee, set up a task force to look into this repo market and recommend what changes needed to be made to make it less vulnerable to shocks.
The task force issued a preliminary report in December, and as you might expect, found that the repo market system was simply not capable of absorbing the impact of a major dealer failure, as happened with the collapse of Lehman Brothers. Beyond this, however, they also found that the “haircuts” — discounts applied to collateral to bring repo deposits to market valuation — quickly generated a liquidity problem themselves as participants scrambled to minimize their risk positions.
The findings and recommendations of the task force are very much a behind the scenes operation. Even though they have published their initial report it is unlikely to be a best seller or become a movie script.
The repo market’s inner workings are far too technical to be hot news, but they are very important. Repo market transactions were supposed to be, and actually are, the most secure financial transactions available to banks and individuals. If we cannot straighten out this market and make it less vulnerable to credit crunches and market anxiety attacks, there isn’t much hope for cleaning up the rest of Wall Street and protecting us from another financial crash.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
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