Today's dumb question from the back of the Finance class. (But I would guess some other students might not know the answer either, and some maybe hadn't even thought of the question).
[Update: just to be explicit, I am not asking why lenders want security for loans. I am asking why I don't sell my watch instead of pawning my watch.]
I want to borrow $80 for one month. I have a watch worth $100. I go to the pawnbroker, hand over my watch as security, and borrow $80. I promise to repay the $80 plus interest next month, and the pawnbroker promises to give me back my watch if I do this.
That's like a "repo", which is short for "sale and repurchase agreement". It is as if I had sold my watch for $80, and the pawnbroker had promised to sell it back to me, and I had promised to buy it back from him, for $80 plus agreed-on interest next month. If I borrow $80 on a watch worth $100 there's a 20% "haircut". (The difference is that in a repo I get to keep wearing the watch for the month (I get the coupons on the bond) even though the pawnbroker legally owns it.)
Why don't I just sell my watch instead, then wait till next month before deciding whether to buy it back?
Why do I and the Pawnbroker choose to agree in advance on what we will do next month? Why don't we just wait and see what we will want to do next month? The future is uncertain. We usually wait to get as much information as possible before deciding what to do. We might change our minds when we get new information. If we do make promises about what we will do in the future, there must be some reason that outweighs the benefits of making that decision with better information when next month arrives.
Three possible explanations that come to my mind:
1. Maybe this particular watch has sentimental value, because it used to belong to my grandfather. It's worth $150 to me but only $100 to anyone else. So there's not a competitive market in this particular watch. If I sold it, and then wanted to buy it back, the repurchase market would be a market with bilateral monopoly. The new owner would have monopoly power, and I would have monopsony power. We would haggle over the distribution of the $50 gains to trade. That haggling would be costly, and the outcome would be uncertain. So to avoid those costs and risks, the pawnbroker and I agree on the repurchase price beforehand. By bundling the sale and repurchase together, the price doesn't matter, as long as the haircut is big enough so the pawnbroker has sufficient security.
Or maybe there's a Market for Lemons problem. Any particular watch might be a lemon (have some hidden defect). The owner will have better information than a prospective purchaser on whether the watch is a lemon. If I offer to sell my watch to the pawnbroker, because I need temporarily need cash to buy something else, he doesn't know if i really need cash or if I'm trying to get rid of a lemon. The repo eliminates the Market for Lemons problem (as long as the haircut is big enough). If I'm selling a lemon watch I'm also buying a lemon watch, because I agree to buy back the exact same watch.
Those explanations make perfect sense if I'm pawning my watch. They don't make sense if I'm pawning a Canadian or US government Treasury Bill. Tbills, for a given issuer, maturity, and "run", are fungible. They are all the same.
2. Maybe there are transactions costs of buying and selling watches. There's a spread between the bid and ask price, even though all watches are (by assumption) the same. The market-maker in watches, who quotes bid and ask prices, always puts a spread between bid and ask prices for fear he might make losses when informed traders, who have better and quicker news about things affecting the future demand or supply of watches, decide whether to buy or sell from him.
By pawning the watch, rather than selling it and buying another watch next month, both I and the pawnbroker eliminate the risk that the other is better informed than we are about whether the market price of watches represents a good buying or selling opportunity.
That explanation might conceivably work for Tbills too. Bid-ask spreads are very small, but not zero. But it's not obvious whether it works empirically. Are the transactions costs of a repo lower than on two separate trades?
3. The future price of watches is uncertain. If I know I will want to have a watch again next month, it is as if I have a short position in one future watch. If I sell my watch, I face the risk that the price of watches will be higher next month, when I buy a replacement. If I am risk-averse, I will want to cover my short position by agreeing now on a price at which I will buy a watch next month. I buy a future watch, Cash On Delivery (because I don't have the spare cash now), to cover my short position. Pawning the watch covers my short position, and eliminates the risk.
That explanation too might conceivably work for Tbills. If I have a portfolio full of Tbills, for safe income in my retirement, but I need cash now for a month, I might borrow rather than selling my Tbills. Because if I sold my Tbills there's a risk the price might be higher next month, so I would be able to buy back fewer and my retirement income would be lower. I have short position in safe retirement income that I initially have covered by my ownership of Tbills. When I sell my Tbills I now am net short again. But if I repurchase at the same time I immediately re-cover my short position.
But it's not obvious whether it works empirically. Do the people pawning their Tbills have a future need for those same Tbills for some other purpose? Are they pawning Tbills that have a considerably longer maturity than the loan, and then hanging onto those Tbill after the loan is repaid?
Those three explanations are all I can come up with. Which one of those three explanations (presumably not the first) applies to repos of Tbills? Or are there other explanations I've missed?
Why do I ask? Well partly just out of interest. But also because I think that the answer to the question "why does repo exist?" might matter for monetary policy.
1. Sometimes central banks do repos (and reverse repos, which are exactly the same only with the central bank on the other side of the deal), and sometimes they do Open Market Operations (either sales or purchases of bonds). Whether it matters whether central banks use repos or OMOs, and how it matters, might depend on why repos exist.
2. Some economists have said that there is a shortage of safe assets for repos. And some (I think) have said that central bank OMO purchases worsen that shortage of safe assets for repos. I would understand these questions better if I understood better why repos exist. (If the central bank buys bonds for cash, why do people need the bonds for repos, when they already have the cash?)
Worthwhile Canadian Initiative 
K, Ashwin
I think I made lots of implicit mental model assumptions, so let me try to clarify.
I understand the bit about repo simply being a collateralised loan, except even cheaper than a collateralised loan due to the legal treatment as a sale. Consider the example of t-bills for a moment. Now why does it matter whether it is the bank or the non-bank holding onto the bill – if the bank wanted its cash back tomorrow, it could easily liquidate the t-bill tomorrow. Presumably the bank really cares about the one day price risk of a t-bill. Which it has priced in by offering the repo at a cheaper rate than the corresponding secured loan. It is operating at its indifference curve, so to speak.
So the repo transaction has achieved exactly one thing – it has kept the one-day price risk of a t-bill with the non-bank rather than the bank. I was finding it difficult to imagine why different entities would evaluate about a ‘money’ asset like t-bill so differently, so I guess I made some implicit assumptions when putting forth my point about roll-over risk.
Say that the 30 day t-bill would have traded at 0.55% had there been no repos and the bank would have been forced to buy the t-bill. Now that we have repos, the economic risk is better allocated and the non-bank is happy to hold it only at 0.5%. Why is it accepting the 5 basis points on t-bills lesser than the bank? Presumably because it is assuming that it will be able to roll over its repo tomorrow. If the investors (banks and non-banks) were doing pure ‘credit’ risk pricing, t-bills would have been 0.55%. Now that the investor (non-bank)is doing a roll-over risk pricing of t-bills, she is willing to accept just 0.5%. This is the ‘mis-pricing’ that i was talking about. There is cheaper funding everywhere, yes, but only because credit risk assessment has been converted to a roll-over risk assessment. The 30 day loan has been converted to 30 one day loans. Note that the non-bank does not really benefit in the net. Presumably, whatever it has gained through the cheaper rate of repo borrowing, it has already lost through the lower yield on the t-bond.
The other way to posit things would be to say that the non-bank genuinely has greater utility from/ need for a t-bill, between today and tomorrow, than a bank. Hence the repo market has helped the market achieve the social optimum. That seems a bit hard to digest.
Note that things remain the same even with longer bonds/ ABS. Assume for a moment that the ABS is actually being priced ‘right’, so that a AAA tranche used as collateral is actually AAA. Again, the only risk that is being borne is the one-day price risk. If the AAA model is working fine, the only reason it matters whether it is the bank or the non-bank holding on the price risk is if the non-bank really derives more utility from holding the AAA asset than the bank for a day, each day. And it has already paid for that utility by accepting a lower return on the AAA asset, than if there was a counterfactual pure credit risk pricing of the asset.
One can see why securitization of the final loan would bring down interest rates through a better allocation of risk to whoever wants to hold it. But once the underlying asset has been securitized (or is already a security, like a T-bond), the repo market lowers rates all around only because repo-borrowers, whoever they are – banks or non banks – are systematically saying that daily roll-over risk is cheaper than the daily credit/price risk. The ‘correct allocation’ of economic risk (to the bank rather than the non-bank)over the 30 days or the 30 years does not really matter, because whether held to maturity or sold in between, the credit/price risk of the security is the same for the bank and non-bank. If the non-bank is more willing to hold this economic risk than the bank, it has also accepted a lower yield for doing so.
And that leaves the final question of – if the utility function of banks and non-banks really is different, with banks not wanting the one day price risk, why is that the utility function of the banks? Perhaps because they also have one-day liabilities – money market deposits.
Which is why I said that the market for repo arises from some combination of mispricing of roll-over risk and a greatly increased money demand. Securitization arises from the need for cheaper credit/ leverage achieved via a ‘better’ allocation of risk. But not repo of the securities themselves. That is pure portfolio money supply being created to match portfolio money demand.
(apologies, but skipped the comments)
Nick, I think for financial assets you are right about points 2 and 3. In gold markets, for instance, you’d rather lend or swap (ie. repo) your gold than sell it (upon the anticipation of buying it back at some future point) because you might fear that, come time to buy the gold back, the future price could be much higher, or that the gold market could be illiquid and you might not be able to buy.
Incidentally, you can also sell your gold and buy a futures contract. Selling spot and buying a futures contract is financially equivalent to swapping (repoing) gold – in both transactions you’ll lock in a guaranteed price and will avoid the risk of illiquidity. So your question: why repo? is similar to the question: should I sell some asset and simultaneously buy a futures contract or sell it and take the risk of buying back at spot at some future point in time.
So, the purpose of a repo is to buy liquidity when one holds an illiquid asset. In return for a fee and the possibility of losing the asset one can obtain cash (or some other more liquid asset).
Ok, let me have one final go at clarifying what I really want to say.
There are 4 types of loan transactions
1)Uncollaterlaized loan – Has counterparty risk. The lender’s valuation tree is 0 or payout. Hence, full payout is a high number, say 105 for 100 lent out.
2) Collateralized loan – No counterparty risk, only price risk. Lender’s tree is payout or asset. Hence the price risk of the asset is borne by the lender. But the lender still has the asset, so full payout is a lower number, say 103 for 100 lent out.
3) Sale today, repurchase tomorrow at tomorrow’s price – This is a collateralized loan + a buy-back guarantee. So full payout is an even lower number, say, 102 for 100 lent out.
4) Repo (sale today, re-purchase tomorrow at a fixed price) – Collateralized loan + buy-back guarantee + price guarantee. So the lender’s valuation is payout or fixed price asset = simply payout. This is a truly risk-free loan. So full payout is the lowest of the four, say 101 for 100 lent out.
Now Nick is modelling the repo as 3, and wondering if the buy-back guarantee which is the difference between 2 and 3 is really economically beneficial to the transacting parties. He is also wondering about the existence of 2 itself, as a corollary issue.
K/Ashwin are showing that a repo is 4, not 2 or 3 (and also showing that 2 and 3 are themselves different). Which is fine.
My question is – what is really the difference between 2 and 4 which reduces the interest charged from 3% to 1%? Ashwin says that a bank does not want to hold on to a 30 year bond, and so would have to enter a rate swap to get what it really wants. It does both transactions with the same party, and hence charges only 1% not 3%.
Fine. But the bank does not have to hold on to the 30 year bond for 30 years. It does not really face the interest rate risk. The repo loan has only been extended overnight. Purchasing power has been created for only one day. Had there been no repo (and so the asset was the bank’s rather than the non-bank’s), the bank would have simply liquidated the position tomorrow, bringing purchasing power back to where it was (this is equivalent to a repo not being rolled over). The only risk it bears is the risk of singe-day price movements.
So my questions (and answers) are:
1) What is it that makes the bank so risk averse that it does not even want to hold on to a AAA asset, and only wants to lend for one day at a time? My answer is – demand for money market deposits.
2) Given that the repo transaction enables the one day price risk to remain where it is supposedly most efficiently held (with the non-bank rather than the bank), this will be factored into the pricing of the AAA being used for collateral. So, AAA assets are already trading at a discount to where they would have traded in a world without repo where both banks and non-banks had to hold them. The non-bank thus has a lower rate on loan achieved only through a lower yield on its asset. This part of its net benefit washes out. So any net benefit that arises to it is only because it is borrowing successively at a one-day horizon. But presumably it would have to keep borrowing every day, i.e. the system is underpricing roll-over risk.
The bank accepts peanuts due to its risk aversion. The non-bank net benefits by the under-pricing roll over risk. The borrowers at the end of the AAA asset benefit, but their main benefit was already achieved when their borrowing was securitized. Its successive repo-ing is not particularly necessary for them.
K: “I think this is always the core function of a repo trade: to enable the lender (of cash) to reduce market exposure, and the borrower to increase it.”
I won’t quibble too much with this, because it’s very often true (like in my original example), but I’ll quibble a little. You can repo assets completely unrelated to the lender. Lender A provides repo to buyer B who bought assets from seller C. It happens because A hopes to do business with B in the future, and that “business” may not involve buying/selling assets at all.
Ritwik,
I think you are complicating things, and there is some stuff I don’t agree with…
“2) Collateralized loan – No counterparty risk, only price risk”
Don’t agree. The collateral is only in case the counterparty defaults. So there is default contingent price risk. If the borrower is risk free (e.g. the CB) then the loan is at the risk free rate and the presence of collateral is irrelevant.
“3) Sale today, repurchase tomorrow at tomorrow’s price – This is a collateralized loan + a buy-back guarantee.”
Not the way I see it. A decision to buy something tomorrow is of no economic consequence. You can change your mind any time between now and then. I don’t see any loan here, or any guarantee. This is just a sale today plus, as always, decisions to be made in the future. Everything else is irrelevant.
“4) Repo (sale today, re-purchase tomorrow at a fixed price)”
Agreed, but…
” – Collateralized loan +buy-back guarantee + price guarantee.”
Now I’m confused. There is no plus “buy-back guarantee + price guarantee.” A repo is economically exactly equivalent to just the collateralized loan. The only difference is that under bankruptcy the priority of claims on collateral can be complicated under some circumstances, in some jurisdictions. But forget that. For our purposes, just assume that if the borrower defaults, the lender keeps the collateral, and makes a claim in bankruptcy of an amount equal to the difference between the loan amount and collateral value at the moment of default. That’s how it’s supposed to work, and in that case there is no difference between the 2) collateralized loan and 4) repo.
If you have a repo with a very large haircut, or equivalently, a loan with a very large amount of excess collateral, the loan and repo rates will be exactly equal to the risk free rate. So in summary, 2) and 4) are the same, and identical to 1) if the borrower is risk free. 3) is just a sale, which is nothing like the other three, which are loans.
[I’m ignoring the case where the lender chooses some special collateral. The present discussion is for the case of general, arbitrary collateral with no convenience yield serving only as security against the loan]
“what is really the difference between 2 and 4 which reduces the
interest charged from 3% to 1%?”
Ignoring said legal difficulties of actually taking collateral in some cases, none at all. The rates are 1) identical 2) equal to the risk free rate if there is enough good collateral.
“But the bank does not have to hold on to the 30 year bond for 30 years. It
does not really face the interest rate risk. The repo loan has only been extended overnight.”
I don’t follow. If you own a 30-year bond, you have a lot of rate risk. It’s a very volatile instrument, whose value changes (in real or nominal terms) as much as most stocks. Repoing it has zero impact on your risk profile. As I and Ashwin have said above, repo (or borrowing against collateral) does not transfer the economic risk of the collateral. Repo is not about transferring collateral risk. It is about lending, and possibly enabling the parties to make other trades that do transfer the risk of the collateral assets. See MP’s very illustrative comment above.
In your last few paragraphs, you seem to be considering the case of repo as part of enabling a bank to unload a troubled asset (MP’s example). That’s one interesting theme, but by no means the principle volume of repo. The vast majority consists of trillions of dollars daily of overnight risk-free loans from one financial institution to another. If you want to answer the question of why, in general, we have repo, you need to consider all of it.
Good Lord: what a lot of comments! I am late to the party and I hope I don’t repeat something that’s been said already – I have just been able to skim through the bunch.
Nick: I think the pawnshop analogy may mislead. The difference, as you note, is that the borrower in a repo still in effect owns the bond – or gets the returns from it, at any rate. It would be as if I pawned my guitar but still were able to play it whenever I wanted. Then why would I not sell it? Because I want a guitar to play and I don’t want to tie up all my funds in the investment. I take 500 dollars of my own and buy a guitar. Then I sell it to you for 400 with an agreement to repurchase it tomorrow for, say, 405. I take the 400 dollars and do whatever I like with it. Tomorrow I see if you’ll rollover; if not, I find someone else to buy it under repo, repaying you out of the proceeds. I play whenever I want and I value daily “guitar services” at north of $5/day.
MP,
I think you are not properly closing the loop in the monetary system. Lets say that C has a bank, D. As B’s deposits move from A to D bank, A must transfer reserves to D to compensate them for assuming that liability. Now A is short reserves and D has excess reserves. In order to flatten their reserve positions (without changing their risk profiles), they do a GC repo trade sending the reserves back to A. Now A just has two offsetting repo trades (which only differ by the type of collateral and the rate). So A is not at the end of the repo “chain,” because A borrowed the money from D who borrows the money from C (the deposit), who was unloading market risk.
Any time somebody buys something from someone else, there is an instantaneous chain of (hopefully) risk-free loans that propagate through the banking system from the seller to the buyer. If the buyer is purchasing a capital asset from the seller, that produces an offsetting increase in the risk-free short rate asset by the seller and an equal decrease in that asset by the buyer. That chain is effected through the financial system via repo loans. This is the sense in which I’m saying that a repo always involves a lender trying to decrease market exposure and a borrower trying to increase it. It’s that the ultimate lender is always the seller and the ultimate borrower is always the buyer.
Maybe that’s all trivially obvious and pedantic. I find it somehow enlightening.
I’m way behind in the comments here.
But I wanted to take another stab at the (original) question, which was “why borrow against collateral if you can just sell the collateral”.
Without disagreeing with any of the offered explanations — transaction costs are higher, accountants don’t want to mark the asset to market — I want to try to make a simpler explanation which, I believe, generalizes the others.
There is heterogeneity of beliefs as well as financing needs. Everyone who is long an asset thinks it is worth more (to them) than the market price, and everyone who is short an asset thinks it is worth less than the market price. The market price is the average of these. Here, “worth more” also includes non-price properties in the sense that the owner of the asset values the duration of the asset more than the market, or they value the risk profile more than the market.
This divergence of believes is the fundamental (e.g., non-technological) source of bid/ask spreads, as well not wanting to mark to the market.
If you are long collateral, you do not want to sell it right now for what you believe is less than its value to you because of a short term funding need. You only want to sell it when the market price is such that the market values the security more than you do.
But you may have a short term liquidity need for cash in the present. It is better for you to keep the undervalued collateral and use it as assurance against your default rather than sell it.
rsj,
Yes. And the fact that you use a particular asset as collateral against a loan is completely unrelated to whether or not you’d sell that particular asset if you weren’t able to get the loan. If you were going to sell some asset to get cash, you’d rank all your assets by how much you think they are undervalued, and sell the least undervalued asset, or something like that. Totally unrelated to which of your assets might be most suitable for a collateralized loan.
There is simply no relationship between the desire to sell a particular asset and the choice of using that asset as loan collateral. Unrelated decisions, nothing to do with each other, shouldn’t ever be discussed in the same context.
If I need cash I first have a choice to make: sell something or get a loan. If I decide to sell something, maybe the vintage Ferrari is a better idea than the house. If I decide to get a loan, I’ll probably use the house, and not the Ferrari, as collateral. The fact that I used the house as collateral is in no way or shape evidence that I don’t want the house or would consider selling it.
K,
Agreed. If you were forced to sell an asset to cover the loan repayment, or if you could not get a loan (say the market was not working) then you would sell the least undervalued asset first. Because that is idiosyncratic to you, there is no reason to believe that the least undervalued asset is the most suitable for collateralizing the loan.
In fact, if anything, you would expect a negative correlation, because the best collateral is stable in value whereas there is likely to be greater disagreement about assets more volatile in value.
And here again, undervalued refers to your own peculiar set of plans and needs, and not necessarily because there is a disagreement about payouts (although there may well be a disagreement).
Edmund: “Looking over the comments, I mostly see convoluted forms of, “Yeah, two and three are basically right.” Makes sense.”
That’s the sense I get too. Except “convoluted” isn’t really the right word. What they are mostly doing is giving more specific and realistic examples of my #2 and #3, which I only sketched in the most stylised way. They are putting some real-world flesh on my #2 and #3.
And you could read rsj’s 4.59 as saying “Hey Nick, your #1 wasn’t so daft after all, especially if you get to wear your watch even while it’s in pawn (which you do in a repo, because you get the coupons on the bond). The very fact that you own your watch probably means you value it more highly than anyone else, for whatever reason (it doesn’t have to be sentimental value)”.
Which makes me wonder if my #1, #2, and #3 really are separate and distinct. There are really three questions: transactions costs of buying and selling watches; my valuing a watch more than the market; my valuing this particular watch more than the market.
What I am still mulling over is how those three questions are related, in the explanation of repos.
BTW, Arnold Kling gives basically(?) the same answer as Michael above. It’s the bond dealers.
Nick,
I think Andy’s answer is quite misleading. Yes, auto dealers finance their inventory. But compared to the financing of consumer owned vehicles, dealer financing is very small. It’s the same in the securities financing world. Some people want to have more assets (cars, bonds) than they can afford and some people want to hold less. The people who want to hold less provide loans to the people who want to hold more, who then take their borrowed money, buy assets with it, and use those assets as collateral against the loan. Intermediaries like car and bond dealers and their minuscule inventories are irrelevant in the big picture.
K
Ok, got it. A repo is just a collateralized loan. It increases the borrower’s balance sheet, as well as the lender’s. An outright sale does neither. So the ‘why borrow against collateral’ question reduces simply to ‘why borrow’, and the answer is just as trivial.
I think the dealer example is interesting because it helps clarify something about repo that ‘borrowing against collateral’ perhaps doesn’t. The collateral does not necessarily precede the borrowing. The borrowing is needed to purchase the securities, which then serve as collateral themselves.
Secondly, while dealer inventory many be miniscule compared to the stock held by investors, dealer inventory may be turned over several times in a week, while the extra securities purchased by investors in a week may be trivial. Which is to say that from the perspective of financing, dealers may be a bigger chunk of the repo demand than the investors.
In this sense, dealer financing through repo is a sort of ‘real bills’ discounting – a kind of working capital financing. The term of the repo should match the average holding time of each security on the dealer’s balance sheet. Investor financing through repos is liquidity transformation – they should have ideally taken out a loan/bond that’s roughly in line with the term structure of the assets that they propose to hold (like how households get 30 year mortgages). The fact that investors are able to engage in maturity transformation beyond having the mandate to do so explains the explosion of repo beyond its ‘socially optimum’ levels, and is a consequence of the demand for money market deposits from the supply (of repo) side. Yeah, I’m sticking with the money demand story. 😉
Ritwik,
When you say “money demand” you mean desire to hold non-interest bearing money, rather than t-bills because you might need to buy something?
K
I mean the desire to hold money market deposits, which are more ‘money’ than t-bills and yet pay interest in excess of bank accounts (and close to t-bills). Zoltan Pozsar/ Manmohan Singh have documented how a big part of this demand comes from asset managers who actually have the mandate to invest into long term securities (for cash management as well as principal protection purposes), thus inverting the entire logic of maturity transformation. I am suggesting that this money demand is the ’cause’ of the desire of banks to repo-lend.
Nick,
Your alternative explanations include the following wording:
1 “the outcome would be uncertain”
2 “eliminate the risk”
3 “the future price of watches is uncertain”
These are all variation on risk management.
BTW, the same thinking applies to the JP Morgan “London Whale”, in which everybody was asking – why didn’t JPM simply exit the position instead of trying to re-hedge it? In both cases, it’s a choice between selling the position or financing it in some sense. And you finance it if you think your expected forward position will be superior from a risk management perspective.
With reference to K’s general explanation, you cannot disengage the holding of the asset from the decision to repo it in order to raise cash for purposes that you claim to be independent of that asset in particular. This is because, if you don’t repo the asset, the financing for that asset must be traced to another source. Balance sheets must balance. So then it’s a matter of comparing those two marginal financing costs. There’s no free lunch in terms of just pretending to choose an asset from somewhere in the portfolio to repo for purposes of raising cash that you claim to be quite separate from financing the asset itself. The choices in term of the effective marginal funding cost for that particular asset must be part of the equation. Otherwise, you delusionally think that you’re raising cash by repoing a “freed up” asset – when the alternative/existing financing cost for that asset might itself be more expensive than the repo opportunity. It’s a case of false “mental accounting” or false compartmentalized accounting.
BTW Arnold Kling’s explanation is a simpleton second hand version of a general operational description, based on his reading of a 30 year old textbook on the money market (I bought it 30 years ago). Does the fact that it comes from an economist make it extra noteworthy? (an economist with zero exposure to the actual market, obviously, given his reliance on a textbook resource). Nothing wrong with his observation, but since an economist said it, you pay new attention to that operational perspective?
JKH: Some of those risks refer to transactions costs and non-fungible assets, and others don’t. If you are a monetary economist, like me, (and if you are looking at possible relationships between repo and the demand and supply of money) that distinction is absolutely crucial. Because in a world of zero transactions costs we wouldn’t use money. And the ability of money to lower transactions costs depends a lot on money being fungible. So distinctions which might appear irrelevant to individual participants in repo markets will be very relevant to me (and vice versa). Famous “fallacies of composition” tell us that the individual’s perspective doesn’t always add up at the aggregate level. For example, each individual can always sell/repo his bonds, so thinks his bonds are very liquid. But it’s not possible for all individuals to sell/repo their bonds at the same time.
Arnold Kling has extra credibility. He understands money/macro. Plus he worked for Fanny (or was it Freddy?). He’s got both perspectives (or should have).
(BTW, did you read my (second) response in comments to Tom Hickey, and his good reply?)
Yes, Nick. Good exchange there.
In terms of the economist/philosopher fusion, maybe you’ve covered this, but here’s a follow up question:
When you ask the question “Why do repos exist?” can you answer that effectively without also answering the related question “how would they not exist?”
Meaning – how would the world look if they did not exist?
Would there be an alternative form of collaterized financing using the same asset?
Would such collateralized financing instead disappear altogether?
If it disappeared, how would holders of Treasury bonds finance those assets?
And how would the Fed operate?
Etc.
So it becomes a bigger question, doesn’t it?
An almost impossible question?
But maybe you’ve covered all that because I haven’t read all comments closely.
But is the question framed as precisely as it should be?
My reading of it roughly is that your question implies a specific counterfactual by comparison – which is the open risk sale and buy back rather than the contracted sale and buy. And that would be a narrower question.
But maybe I’ve missed something bigger.
Nick,
Maybe I missed this as well, but did you compare barter repo with barter open risk sale and buy back?
The risk analysis should be the same as with a monetary economy.
Don’t bid ask spreads also exist in barter transactions?
And I’m not sure you can separate the issue of transaction costs from that of risk.
JKH: Good comment.
“So it becomes a bigger question, doesn’t it?” YES!
“But is the question framed as precisely as it should be?”
No. My question wasn’t framed as precisely as we would want it to be. But a large part of what we are really doing when we ask a question like “Why does repo exist?” is trying to explore what those counterfactuals might be.
Why do I (and the pawnbroker) repo my watch for one month? As an alternative I could:
1. Not do any exchange at all.
2. Do an unsecured one month loan.
3. Sell my watch
4. Sell my watch and buy it back one month later.
5. Sell my watch and buy another watch one month later.
6. Sell my watch, and buy another watch forward from a different person (not the pawnbroker)
7. Do something else…
And part of asking the question is to try to figure out what all the (relevant and interesting) alternatives are.
In other words, you don’t really know what the question is when you ask it, and the only way to figure it out is to ask it, play with a possible answer, and then see if that answer covers all the possible counterfactuals.
(Plus, an answer that works well if I’m repoing my watch might not work at all if I’m repoing a Tbill (and maybe vice versa), so we are trying to figure out the range of applicability of a possible answer.)
And this is why the comment thread has been both so interesting and at the same time so “all over the map”. It has to be all over the map, just because people have very different counterfactuals (implicitly) in mind. And some people, with one counterfactual in mind, and hence one answer in mind, may think another answer makes no sense at all.
At one extreme, someone who thinks the counterfactual is “do nothing”, is going to answer: “Because I need the cash, duh!”
And close to that, a person who thinks the counterfactual is “do an unsecured loan” is going to answer: “Because the lender needs security, duh!”. (But even in that case, it’s not quite so obvious, because sure the lender wants as much security as possible, but the borrower doesn’t, otherwise all loans would have a “pound of flesh” clause attached.)
Nick,
That makes sense, as a process of exploration and development of question and answer together.
So do you have a “most universal” “answer in progress” to your question at this point in time?
And one of the reasons I’m talking about pawning a watch rather than repoing a Tbill, (even though the analogy is not as good as I want it to be, because I don’t get to wear the watch when it’s at the pawnshop, and I have the option rather than the obligation to buy it back) is to try to push the operations people outside of their comfort zone, where everything is familiar to them, and they take it all for granted, and see if we can come up with a general theory of repo, as well as explore the similarities and dissimilarities between different types of exchanges. Because at one level a repo is just an exchange, and like all exchanges, the explanation to why it happens is that both parties (think they) benefit. But how can both parties benefit at the same time? Comparative advantage, different preferences, etc., there’s a whole slew of economics devoted to trying to see a multitude of different exchanges as being fundamentally the same.
JKH: “That makes sense, as a process of exploration and development of question and answer together.”
Very good way of putting it. Which is why it looks like a confused mess. Which it is, in one sense.
“So do you have a “most universal” “answer in progress” to your question at this point in time?”
I keep thinking I do, starting to write it up, then realising I don’t. Or I haven’t got the answer in its simplest and most general form. I think some sort of “transactions cost” will be a necessary part of any answer.
Maybe some day there will be a 4.00am post on the subject!
JKH,
I don’t disagree with what you are saying (as discussed above), but I think it’s somewhat beside the point. But let me rephrase my point then, with better attention to details of “special” repo.
Assume that the portfolio is made up assets, some of which can be repoed below the risk free rate. When you buy such “special” assets, you do so with the intention of repoing them since otherwise you are getting arbitraged. In fact, you borrow against each such asset until the marginal cost of additional borrowing is equal to the risk free rate. And when you evaluate the risk/return characteristics of each asset, and decide on portfolio construction, it is in the context that the asset is financed by that level of borrowing. In that context, additional borrowing is at the risk free rate, generally by borrowing against non-special assets. (Or possibly above the risk free rate as you get to very small haircuts or try to repo illiquid and opaque assets). Similarly, the decision to deleverage is achieved not by reducing repo on special bonds, but by parking part of your assets at the risk free rate (e.g. in a GC repo).
So if, for special bonds (and stocks), you define “asset” as a combination of the security and special repo, and define the “asset” amount as just the haircut, then it is true that you can segment the portfolio construction, and leverage decisions.
And yes, that’s a slight fudge, and yes there are even more technical details we can consider, but I don’t think any of it casts any particular light on the fundamental reason for the existence of repo, i.e. to construct a risk-free loan from relatively risk-averse to relatively risk-seeking investors to enable each one to tune her risk asset exposure to levels above or below her total wealth (and even to negative amounts of risk asset exposure). If somebody wants to decrease their asset holdings, then (barring a wealth transfer) it’s impossible to achieve that without:
1) somebody else increasing their asset holdings, and
2) the first person providing a loan to the second person.
It’s a no-brainer that the loan should be collateralized, given the extra asset holdings. That’s why we have repo. It’s the same role that is always provided by the banking system, but just for securities.
JKH: “Maybe I missed this as well, but did you compare barter repo with barter open risk sale and buy back?”
No, I didn’t. But I should. Two of the goods in a repo are: money; an promise to pay money next month. And I’m trying to figure out whether that is an essential and interesting feature of repo or just a simple corrollary of the fact that almost all exchanges are monetary rather than barter.
“Don’t bid ask spreads also exist in barter transactions?”
Yep, and they are presumably bigger, which is why we use money.
“And I’m not sure you can separate the issue of transaction costs from that of risk.”
Yes and no. We can have risk without transactions costs. And the sort of uncertainty that creates transactions costs (e.g. “does he know this car he’s selling me is a lemon?”) may be very different from market risk (“Car prices may rise or fall next month”). Market risk may motivate trade. The risk the car is a lemon reduces the amount of trade.
Nick
The ‘general theory of repo’ seems to me to be currently pointing at :
1) Working capital financing of dealers (which has always been on a ‘real bills’ and hence risk-free basis), where the short term of the repo matches the frequent inventory turnover of the dealer.
2) Maturity transformation by investors.
3) Splitting of the ‘funding’ and ‘taking risk’ portions of the act of lending, so that we get to a model of banking where the ‘bank’ does not need to have ‘assets’ and we can focus on its liabilities. You thus get the true risk-free ‘time preference’ rate of the economy. (I should note that many central banks call the interest they pay on excess reserves the ‘reverse repo’ rate, including the Reserve Bank of India)
4) Money demand, in its modern form.
I don’t know if you agree, and if you are able to map this to your initial three propositions.
To your point about how both parties benefit, I think it’s important to come back to what SRW recently said is the essential nature of a bank – that its liabilities are widely circulated as money even though it does not have enough capital. The ultimate repo originator is the ‘bank’. A repo loan, thus, is the only asset that a Friedman-ite bank holds.
All this while we must keep in our mind that out there in the money/ capital market, funds and investment banks often play the role of bank, dealer and investor at the same time, creating an ungodly concoction.
JKH: In fact, “would there be repo in a barter economy” is an interesting question. And if the answer is “no”, then part of the answer to the question “why does repo exist?” must be “because we live in a monetary economy”.
Ritwik: “1) Working capital financing of dealers (which has always been on a ‘real bills’ and hence risk-free basis), where the short term of the repo matches the frequent inventory turnover of the dealer.
2) Maturity transformation by investors.”
I can see those as being empirically important, but not theoretically important. (Howls of outrage!). Because we also pawn/mortgage/repo real assets like watches and houses, as well as bonds, and a general theory would see bond dealers and maturity transformation as just particular examples (albeit common and important examples) of a more general explanation.
“3) Splitting of the ‘funding’ and ‘taking risk’ portions of the act of lending,…”
When I mortgage my house, rather than selling shares in my house, or renting and buying shares in a real estate investment trust, it’s true I am taking the risk on my house rising or falling in value due to market changes. But I am also resolving the moral hazard/principal-agent problem that renters may not take care of a house.
“All this while we must keep in our mind that out there in the money/ capital market, funds and investment banks often play the role of bank, dealer and investor at the same time, creating an ungodly concoction.”
Yep. Which suggests that yet another counterfactual to “why repo?” is “why not banks instead?”
Nick,
– And if the answer is “no”, then part of the answer to the question “why does repo exist?” must be “because we live in a monetary economy” –
Yes. That logic was roughly the reason for my question. Off the top, I’m guessing that the repo question generalizes to both barter and monetary, as does the related bid ask spread question. (And maybe there’s just a single generic version of collateralized borrowing in a barter economy.) So it’s a pretty big question.
I’ll be watching for that 4 a.m. post.
Instead of repo, I could sell my bonds to the bank, and buy shares in the bank. Wouldn’t something like that be equivalent, in some sort of Modigliani-Miller sense?
Nick,
I like the question of whether there’d be repo in a barter economy (I already took a stab at it yesterday at 4:33pm, but I’ll try again). As in the real world there would be young people with little wealth and old people with lots of wealth. The old people would have portfolios made up entirely of real-estate and production goods. The old people have no use for the real estate so they rent it to the young people in exchange for consumption goods. That’s not ideal since the old people have no desire for the market volatility of an asset they never intend to consume, nor do they like the variable rents. Rather, what they want is a guaranteed steady stream of consumption goods. So they arrange an exchange with the young people: the young people get the real-estate and promise to pay the old people the steady consumption stream. The young people agree to commit the real estate as collateral in case they fail on the consumption guarantee. This works well for the young people since they don’t care that much about the market volatility of real estate since they intend to use it for a very long time. Also, it’s easy for them to exchange their labour for the consumption goods they have to pay the old people.
Now I was going to tell the same long story about the production goods (claims on corporate assets), and how repo solves the problem, but I don’t have to. You know exactly what I am going to say.
Nick
If I take out a one year personal loan with my house as a mortgage, I have engaged in maturity transformation. When the auto-dealer mortgages his inventory of cars for a loan, he is financing his working capital.
So I see working capital and maturity transformation (financial or ‘real’) as the two essential planks for a general theory of repo, with bond dealers and securities investors being the empirically most relevant forms.
I don’t quite get your counterfactual. The repo originator IS a bank. Its ability to extend a repo loan freely makes it a bank. Or, more accurately, only banks can extend repos. It doesn’t matter if they are formally incorporated as a bank or not.
K: “I think you are not properly closing the loop in the monetary system.”
Ok, I get it.
K and JKH: Yep, my top-of-the-head response was also that repo generalises to barter. And i was thinking through examples like yours.
But then I thought: we would only have barter in a world of zero transactions costs. One important transactions cost is that people may not deliver what they promised to pay (you can build a theory of “why money” on the premise that monetary exchange is a substitute for personal trust). If people always delivered what they promised to pay, we wouldn’t need securitised loans, and so wouldn’t need repo either.
So now I’ve confused myself even more, and made the question even more undefined!
Ritwik: “If I take out a one year personal loan with my house as a mortgage, I have engaged in maturity transformation. When the auto-dealer mortgages his inventory of cars for a loan, he is financing his working capital.”
I don’t get the distinction. Both I and the autodealer mortgage our real asset for a one-year loan. I am financing my house; he is financing his cars. His reason for wanting to own cars is different from my reason for wanting to own a house, but does it matter?
On repos and banks: is the only difference between repos and banks an artefact of legislation? (If an outside observer didn’t know the regulations and names of things, would he actually observe any difference?)
Ritwik,
I don’t think “maturity transformation” introduces anything new, and I think it’s a potentially very misleading category. What it suggests, to me, is you create a corporation, issue $1m of short term paper and buy $1m of 30-year bonds, magically removing the bonds from the market and replacing them with the equivalent of tbills. This doesn’t work (though it’s a nasty scam that’s sometimes performed by finance for (very) short term gain). What can legitimately be done is to create the same
corporation, but issue $500k of short term paper and $500k of equity and buy the same $1m of 30 year bonds. For the shareholders this has the same effect as buying $1m of 30-year bonds using their own $500k plus $500k from a repo loan against the $1m of bonds with a 50% haircut. That is not a scam. But I wouldn’t call it maturity transformation. You’ve transformed the 30-year bond risk into short term paper risk (negligible) and equity risk. The equity holds essentially all of the market risk of the 30-year bonds. The duration risk is still all there and can’t be “maturity transformed” away.
Nick: Agreed, banks and repos are the same thing. Bank equity = repo haircut.
A better question would be why do unsecured loans exist. As other commenters have explained, repo is just a legally safe way of securing a loan of money (although sometimes the driving motivation is to borrow an asset offering money as security). I dare say most borrowers have assets comfortably in excess of their liabilities, so if I were lending someone money, my inclination would be to ask for security, and if I sensed a reluctance to provide security, I would be more wary about making the loan. I would only expect unsecured loans to be made when the cost of establishing this security relative to the size of the loan was prohibitively high. And then I would expect the lender to impose covenants and closely monitor the borrower’s financial health, plus charge a higher rate of interest to actuarially cover the default risk. The financial crisis was in part a shock to lenders’ ideas of the state of borrowers’ balance sheets, so it is not surprising that the demand for security and hence the total value of collateral pledged in repos has increased. Naturally, in the face of increased demand for value-stable collateral from private sector lenders, borrowers would be grateful if central banks demanded less or less safe collateral, but that does not mean that the central banks are causing the shortage of safe collateral. The central bank’s choice is not so much as whether to borrow or buy assets as whether to buy secured loan assets from banks or other kinds of assets from a potentially wider range of market counterparties. Central banks will typically borrow a wider range of assets than they will buy, because they hope not to have to take possession of the assets they borrow.
One word: rehypothecation.