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 
Why was it a “dumb” question, considering the discussion sparked here? Am I missing some sarcasm?
I really do not understand the argument of “fooling” people by smart/stupid accountants. What exactly is fooling about here? Your views of accounting are very strange. Accounting was created not to fool people but to inform them. When you open financial statements of a company you should know what stands behind any line there. Surely, companies can try to fool and hide information but that is another story.
So you need liquidity and you can borrow it. Your counterparty has excess liquidity but it does not want credit risk of you (and capital requirements if you are a bank).So you make a repo. For one thing this is how monetary policy in Eurozone works – ECB for all practical purposes does reverse repos with banks. In the system with OMO, the central bank does OMO but these are system-wide operations. They do not eliminate individual liquidity imbalances which have to be re-distributed in the most cost efficient manner. Repos simply provide such manner. If tomorrow somebody comes up with a more efficient way and calls it Oper then Oper will be used. Where is fooling here? Of who and by whom?
Additionally, on financial balance sheets not everything can be sold. Most, and I really mean most here, of the balance sheet can NOT be sold. There is a clear reason why it is done this way, everybody (well, in business) understands it and noone considers it fooling. The reason is that those assets are held for net interest income purposes and not for price volatility/trading purposes. That is the main business of most financial institutions. If these requirements were not clear before, the coming IFRS9 standards clearly require institutions to define and describe their business models for each of their businesses. These business models are audited and accounting treatment of each of them is approved. The purpose of this is transparency and not fooling.
Finally, if you classify your assets for trading purposes (that is for buying and selling) you have a completely different requirements (esp capital) than if you have those assets until maturity. Again, there is no fooling. It is all about transparency and helping people (investors) understand your balance sheet.
Nick – let me try and explain myself in a clearer manner. Let me ignore rehypothecation for now – just complicates the core concept. I’m defining money as purchasing power, the ability to buy stuff in the market – for which I need access to some form of bank liabilities.
First, let me assume binding reserve constraints a la the 50s – in such a scenario the repo works better than the sale to the bank because one has reserve requirements and the other doesn’t (different regs for different CBs – ref the link in my earlier comment).
Now let me throw out reserve constraints – if the bank buys the asset from you and sells it on to another non-bank, it makes no difference. So to create purchasing power ex nihilo, the bank needs to hold onto the asset. It should be obvious why the bank prefers to lend in a near risk-free manner via overnight repo rather than buy risky assets from people. As K said, anything longer than overnight repo is a risky position for a bank (and even overnight repo in times of crisis). So when you say “This looks like the standard loans create deposits story, except that the loan is collateralised.” you are right – what the repo market has done is to expand the breadth of collateral with which this works and to make the process near risk-free (thanks to margining, overnight tenor etc). If increase in purchasing power available to non-banks depended on banks buying up risky assets from non-banks we hit some pretty dramatic limits on bank risk appetite pretty quickly. Repo ensures that for all practical purposes (at least in non-crisis times) there are no such limits.
Excellent!
May I ask, Prof. Rowe, what your take is on the shift from a credit-based system to a repo-based system, we are experiencing nowadays?
Ashwin
I agree with what you/K are saying about the superiority of repo over outright purchases, but ideally this superiority is supposed to be fully captured in the haircut. Why would there be an arbitrage for the bond trader in a normal environment with no CB/ sovereign credit shocks?
My other question is – pre-2008, did the explosion in the repo market service a demand for increase in purchasing power, or was it simply servicing a demand to hold bank-like liabilities that pay more interest than actual bank liabilities? Business investment was dropping, actual consumption was being financed by mortgage equity withdrawals (MEWs) and the like, while it was only deposits with money market mutual funds (many of them actually from pension funds!)that were being serviced by the expansion of repo (both quantity and velocity).
The repo market is simply the future market for bonds. By bundling a purchase with a repo you effectively get a forward position. It’s very common to immediately repo any transaction, often directly with the counterparty. So you buy and sell the bond/asset today, so that only the back leg to the repo is left.
It’s like asking why the future oil market exists. It allows you to go short (sell something you don’t actually own) a specific bond. You cannot have short spot position, but you can go short on a forward transaction.
This simplifies cash management (as there is often little relationship between the value of a bond and its risk) and it eliminates FX hedging requirements (as the repo is in the foreign currency which hedges most of the risk). For example you might want to but bunds, but not euros and the repo transaction achieves that for you (you might need to add a bit for the haircut).
It also applies to all kind of assets: equities, fx, etc…
In all the hedge funds I have ever worked, we never actually own the assets. Everything is always repoed out.
wh,
“step alone”
But yes after that, agreed
Ashwin,
“How can daily repo transactions cost almost nothing, while buying and selling a similarly sized portfolio of Treasuries every day would be completely ruinous? I think the answer is that the bid-ask spread on Treasury securities, like pretty much all spreads in financial markets, arises from asymmetric information.”
Because the net bid-ask structure of repo is symmetrically neutral (sell and buy), and of an outright is asymmetrically preferred (sell or buy)
Nick,
And I was going to suggest to read “k” closely as well
“Nah, the trouble is that other people aren’t thinking theoretically (abstractly) enough! So they can’t see the puzzle! ;-)”
Is the econ blogosphere IN GENERAL asymmetric with respect to mutual liquidity of knowledge seeking between econ specialists and finance specialists?
I suppose that would be natural because econ at the helm of blogging
Pity, because the financial crisis is so important to econ
Repo in finance is a small part of it
But econ could use some term repo at least of finance learning, and with somewhat less avoidance and reflexive rejection of accounting logic to boot
Not to defend the post Keynesians, but their framework is motivated by the desire to repair this asymmetry, I think. And in seeking to repair it, maybe they go a bit overboard at times.
IN GENERAL, Nick
But I’m sure you won’t agree
On transaction costs on repo, I think that a general rule is that transaction cost is a function of the amount of risk transferred in the transaction. Buying or selling a bond transfer a substantial amount of risk between the parties. A repo transaction only transfers a small amount (on an overnight trade almost nothing). The value of a repo almost doesn’t change (it only goes up and down with short terms interest rates, but with a very small daily volatility).
Formal future markets exists for bonds obviously, but many traders don’t like the fixed terms of the product and prefer to trade OTC to the exact conditions they want.
In standard future markets, it’s possible to trade month spreads (e.g. sell nov to buy december). This is functionally identical to a repo transaction. Usually such trades both trade on tighter spreads (usually about half the tick value of teh outright). These contracts are used to keep the term structure of the market in sync and to provide liquidity to teh back months…
varkanut: “Why was it a “dumb” question, considering the discussion sparked here? Am I missing some sarcasm?”
Certainly not sarcasm. Maybe, maybe, just a hint of possible irony. And the discussion it sparked was what I hoped it would spark.
It was a “dumb” question because I didn’t know the answer, and I hadn’t thought about the question, and I hadn’t read the literature. Not my area. But I had read a lot of blogosphere (and some non-blogosphere) discussion of repos, and I can’t remember reading one which gave any sort of deep explanation of why repo exists. It was like reading a lot of articles about insurance markets and not one of them saying anything about risk-pooling. If you are talking about increases and decreases in the size of the repo market, and whether it’s a good or bad thing, and what policy should do about repo, it really might help the discussion to have some sort of theoretical understanding about why repo exists. How are there gains from trade? Why can’t those gains from trade be accomplished some other way? What are the alternatives.
JKH: And you really ought to read this:
Suppose I had asked, in 1957, why corporate debt exists. Why don’t companies finance themselves by issuing shares only? All the practical business people, and all the finance guys, and all the accountants, and all the people who were very close to the markets, would have said: “That’s a dumb (or very ignorant) question. Some people are more risk-averse than others. The more risk-averse want bonds, and the less risk-averse want shares. So the firm can finance itself more cheaply by issuing both.” Then in 1958 two economists, Modigliani and Miller, asked the dumb question, and showed that the standard answer didn’t work. The MM theorem was based on a number of assumptions, under which the debt/equity ratio would be indeterminate. So if you wanted to explain debt/equity ratios, you needed to talk about those assumptions, and which ones were false, and how it mattered. And none of those assumptions were at all explicit in the standard explanation of debt/equity ratios.
MM saw debt/equity ratios as a puzzle. They asked the dumb question. That lead to a much better and deeper understanding of corporate finance.
Pity I’m not Modigliani or Miller. But science starts from seeing the world as a puzzle.
So let me ask this question: would your explanation of repos still work in a world of zero transactions costs? Because you don’t mention transactions costs anywhere. If there are no transactions costs, isn’t it a bit of a fluke that 4 goods get traded in a single transaction, while in all other transactions only 2 goods get traded? Don’t you find that a puzzle, that needs to be explained? There’s a whole literature in economics on tied sales, where 3 goods get traded in a single transaction (money and two other goods bundled together, where the seller refuses to unbundle the two goods).
Oh God, I do hope this comment thread doesn’t degenerate into another heterodox vs mainstream thingy. Mike Norman’s post, and the idiot first comment there, doesn’t give me hope.
JKH: Let me put it this way: Yes, certainly armchair economists like me can learn from finance people and practitioners and accountants. And I’m doing that. But you also have to realise that sometimes our “dumb” questions aren’t quite so dumb as they look, and that sometimes the “answers” to those dumb questions aren’t really answers. Our job is not just to describe the world. And there is more than one way of seeing the world. And some ways of seeing the same world lead to a deeper and more general perspective than others.
I have a question. Are you surprised that the mortgage market exists?
I think there is very little difference between the repo and mortgage market. They are just two forms of secured lending… Obviously the bank doesn’t own your house, but it’s very close… Especially on non-recourse mortgages.
I really don’t see the 3 or 4 goods. A repo is money now vs money later. That’s the exchange. The transfer of the good is just a way to cancel/mitigate credit risk…
acarraro: “I have a question. Are you surprised that the mortgage market exists?”
YES! And you ought to be surprised too. And if you are not surprised/puzzled, it’s because you aren’t thinking deeply and widely enough about why the world is as it is. You are just taking it as given.
For example: suppose I don’t have enough money to buy a house. I could rent one instead, and pool my savings with other people’s savings to own shares in houses that other people live in. In a world of zero transactions costs that would lead to exactly the same allocation of resources and be equally efficient as my borrowing the money to buy a house.
Why do some people rent, and others own? (This is very much like the Modigliani Theorem). In a world of zero transactions costs everyone would be indifferent. There are transactions costs to renting (the tenants may not take good care of the house, they can’t paint the walls the colour they want, etc.) But if there were only transactions costs to renting, and none for mortgages, everyone would own, with a mortgage. So there must be some transactions costs to mortgages as well.
Yes, yes, yes. It certainly is puzzling. A puzzle that can be resolved, but which reappears as puzzling again when you push it deeper.
“I really don’t see the 3 or 4 goods. A repo is money now vs money later. That’s the exchange. The transfer of the good is just a way to cancel/mitigate credit risk…”
Why don’t I do two transactions: I sell my bond to Tom, in exchange for his money now. I then go to Dick, and exchange my promise to deliver money next month for his promise to deliver his bond next month.
ACEMAXX: “Excellent! May I ask, Prof. Rowe, what your take is on the shift from a credit-based system to a repo-based system, we are experiencing nowadays?”
Thanks! I don’t know. We cannot explain why repo is increasing if we don’t even know why repo exists. We cannot fully understand whether it’s a good or bad thing that repo is increasing if we don’t know why it is increasing, and why it exists.
(But I thought it had been decreasing again recently, from something i read somewhere?)
Felix Salmon said that repo is dangerous at the system-wide level. He linked to a Keynesian blogger who was quoting Keynes and then saying that repo just gives the illusion of liquidity, because it’s liquid at the individual level but not at the aggregate level. I have a hunch they are onto something.
Why don’t I sell shares in my house, instead of getting a mortgage? (Why is my house financed by debt plus the occupier’s equity?)
Sergei:
Carleton university has an asset: land that was purchased in 1949. It is still on the books at historic cost, totally ignoring the fact that a 2012 dollar is worth a lot less than a 1949 dollar. “A dollar is a dollar is a dollar”. If we sold that land at current market value, and leased it back, Carleton’s balance sheet would go into an accumulated surplus. That would be a transaction motivated and explained by accounting conventions. If the accountants did inflation-adjusted accounts that motive would be removed.
Acounting takes a large number of numbers and uses conventions to boil them down into a few numbers. Different conventions give you a different bottom line number. If banks did repos under one accounting convention, and didn’t do repos under a different accounting convention, then someone is being fooled somewhere, and that’s the motive for repos.
Bob Smith @10.01. Very good comment. You might be onto something there.
But I didn’t understand this bit: “First, I suppose that there’s a farfetched answer,…”
I know you were just throwing it out there, but you never know..
Different rules for different folks. Cost minimization.
If I hold bills and can do fee-generating transactions that you cannot do (or cannot do as efficiently as me), I come to you to get cash to use in those transactions. I make money. You in turn make money lending to me, in the case in question, doing a repo transaction with me.
What’s the wedge between the fees I hope to earn and the return you hope to earn? Risk. I take more risk, I get a higher return. Standard stuff. Why don’t you simply cut me out and do the transactions that I do? Your rules aren’t the same as mine. You do secured lending because that’s where you fit in the regulatory scheme of things. (In a less regulated environment, such as 14th century Italy, reputational factors and the risk of loss of life serve a function similar to regulation.)
Why repo instead of purchase and then an unrelated sale (or sale and unrelated purchase)? Because both of us are in the business of repeated, predictable transactions. I always do transactions for fees, you always provide secured credit. If we are always going to do the same thing, then the freedom to make some different decision a month from now is not all that valuable. The reduction in transaction costs is very important when you are making a living by collecting a few basis points, over and over.
Different rules (regulations) for different institutions is only one reason that the lender and the borrower in a repo transaction do the same things over and over. Most firms do the same thing over and over. In finance, though, rules are an important factor. The prospectus creates another limit on activity, much like regulatory differences. Client relationships and reputation are yet another. Point is, if you do the same thing over and over, you don’t want freedom to change you mind as much as want to reduce the cost of repeated transactions.
JKH – I think you’re replying to Matt in your 5:06 AM comment, not me!
acarraro @0613 AM makes an excellent point with:
“On transaction costs on repo, I think that a general rule is that transaction cost is a function of the amount of risk transferred in the transaction. Buying or selling a bond transfer a substantial amount of risk between the parties. A repo transaction only transfers a small amount (on an overnight trade almost nothing). The value of a repo almost doesn’t change (it only goes up and down with short terms interest rates, but with a very small daily volatility).”
Ritwik – I’m not sure I understand your first question. Let us take an example where a pension fund that owns 30y T-bonds wants to repo them out for three months because the pension fund actually wants to keep the economic risk of the duration in the bond. Even if the pension fund was fine with giving up the asset, the bank would charge more simply because it would have to enter into an interest rate swap to get rid of the interest-rate risk on the bond.
On pre-2008, it’s hard to say what drove what. I tend to think of the first impulse as the problem of maintaining consumption in the absence of wage growth which necessitated increased leverage. Best way to lever the household while maintaining the appearance of a close-to-risk free financing of this debt is to do this via overnight financing/repo. Financiers pick up the pennies, households get increased consumption and the taxpayer eventually gets run over by the bulldozer when the bill is due.
“instead of doing a repo, I could just as easily do two separate transactions: sell my Tbill to Tom; buy a Tbill forward from Dick”
That would not earn you any term premium, though, because the separate forward transaction would be done at the implied forward value. The point of repo is that the repurchase is done at the selling price, not at the market price. I still agree that transaction costs are a significant part of the story, though.
Nick,
Point taken.
(Although I wouldn’t be surprised if finance people had ventured into the MM intuition independently around the same time.)
Still, it’s a good comparison.
I’m interested in understanding the 4 goods idea.
If an investment dealer issues an unsecured promissory note instead of repo, does that not involve 4 goods by your meaning? He buys dollars spot, sells note spot; sells dollars forward; buys (redeems) note forward.
Substitute repo collateral for promissory note.
So is the 4 goods idea a particular issue for repo?
“Why does a repo have lower transactions cost then the separate sale and purchase?”
You would be price-taking (paying the bid/ask) on both legs of these separate transactions.
I don’t think it’s true that with no transaction cost people would be indifferent between owning and renting. You would still get a change in wealth as house prices go up and down… Obviously it’s simply a transfer between people, but there is a transfer.
There is currently no market where I can exchange my promise of money for his promised of delivering a bond. Actually there is, but only for a few specific bonds. As I said above in exchange traded markets you get the 3 transaction (spot, forward and spread/repo). But this requires 3 prices instead of two. There is an arbitrage between the 3 prices, so the market usually gives you only two prices and you can calculate the third. In some market spot and forward are the quoted prices in others spot and repo…
A repo market is just a different way to quote a forward market, like quoting bond as a price or a yield. There is no economic difference.
Surely we don’t need to explain why we want a future/forward market? To me that’s just asking why we want market in general and that’s a bit too basic…
I really don’t see how repos are dangerous frankly. They are just secured loans. We had secured loans for ages. It’s probably mostly about technology. It’s easier to keep track of the assets than it was in the past so the actual transfer of ownership is the best way to mitigate credit risk. I am not sure what you mean about repo being liquid. The ability to repo is very variable. The credit risk on repo is small as long as the collateral is very good or you have a high haircut. If collateral is worthless, than you get full credit risk on counterparty (and at a bad time, since you know they just lost money of the asset they pledge to you)…
Phil: “That would not earn you any term premium, though, because the separate forward transaction would be done at the implied forward value. The point of repo is that the repurchase is done at the selling price, not at the market price.”
You lost me there. Could you explain that bit more slowly please.
JKH: sorry for being a bit antsy. That Mike Norman post and comment pissed me off a bit, especially after all the angry responses to my first year text post from permanently indignant people with reading comprehension problems.
“If an investment dealer issues an unsecured promissory note instead of repo, does that not involve 4 goods by your meaning? He buys dollars spot, sells note spot; sells dollars forward; buys (redeems) note forward.”
Dunno. I don’t think so. But it’s the right question to ask. My head may become clearer later.
“You lost me there. Could you explain that bit more slowly please.”
I think I misunderstood you – you meant to suggest a series of 1-day separate sales & repurchases, not a term forward (the point being that the repo market is the forward bond market.) Sorry.
Yes, Nick.
I did say “maybe they go a bit overboard at times”.
(Where “bit” is rather flexible in magnitude measurement terms.)
Mind you, he did say “operational answers” in that post.
Just slouching in the direction of wondering about optimization of 2 types of input here.
Maybe it is a bit heretical, but I thought of MM as clever on paper, useless in practice. Does it actually help understand the word? I am not convinced frankly…
There is a certain tendency here to look for the one true explanation of repo, which in my view does not exist. The market has various types of agent and must be structured to satisfy all of them simultaneously. So you have:
1) Large depositors who want a secure demand deposit.
2) Market makers who want to finance inventory.
3) Long investors who want to pick up a bit of yield by lending their securities (sec lending is not economically equivalent to repo – you have to pay to lend money! – but the mechanics are the same and it is part of the same market.)
4) Arbitragers who want to take advantage of anomalies in relative prices.
5) Speculators who want to take an unhedged leveraged or short position.
The market is a jigsaw puzzle and every piece must fit. For example, the depositors who are the ultimate source of funding in the system want good collateral but don’t want to be exposed to the market risk of that collateral; their requirements would not be answered by separate sale and repurchases with different counterparties.
Ashwin
I was referring to K’s argument (perhaps this wasn’t your point)that a repo transaction converts a 30 day t-bill into an overnight loan. Ideally, the superior return and risk on the 30-day t-bill ought to have been captured in the haircut. So why should you do the repo? Is it simply that the credit risk is being converted into roll-over risk, with roll-over risk somehow being mispriced vs. credit risk?
(Is this ‘mis-pricing’ of roll-over risk the key fact that explains the existence of any bank? But I digress.)
I understand your example, where the repo exists to create an avenue for pure funding, without any associated risks. In that sense, the repo market simply exists to minimize transaction costs by combining the two transactions into one. It’s the classic Fischer Black split of each bond being seen as a risk free funding + interest rate swap + credit default swap, the repo removing the need to sell the IRS + CDS together with the pure funding. I don’t think this was K’s point.
I don’t quite agree with your characterization of the drive behind repo markets. My understanding is that households that needed to finance consumption in the face of stagnant wages were able to do so against housing equity. There is no sui generis need to convert this leverage into risk-free financing, as the lending is collateralized/ not being extended at riskfree rates anyway, and household borrowing cycles are far too long(infrequent)to explain the explosive growth of an overnight market.
Ultimately, there has to be some demand for an ‘overnight’ lending, i.e. demand deposits. If it makes 2% return on the side, even better. Stash 80% funds in this, gamble with the other 20%. Isn’t that what most funds were doing/ are doing these days anyway?
Nick,
“Are the transactions costs of a repo lower than on two separate trades?”
It’s definitely not a dumb question, but the underlying assumption seems to be that you can use repo to “replicate” a position in the underlying collateral by simply repeating the repo trade, and that repo is therefore a substitute for outright ownership. This is not the case.
First, a series of overnight short rate loans, is economically not at all the same risk as a term fixed rate loan. Repo is overwhelmingly overnight with long term assets as collateral. So the kind of repo that is actually used in the market cannot and is not used as a substitute for holding economic risk in the underlying asset.
On the contrary:
Lets say you already have invested your entire wealth in various assets, but you would really like to add some 30-year treasuries to the portfolio for whatever reason. So you borrow a some money and buy some long bonds. Now you could get a 30 year fixed rate loan and use it to buy the bond, but then you’d be stupid since the loan and bond would be a wash economically (in reality you’d lose big time since your borrowing costs are higher than the US govt). You don’t want the loan itself to be a market-risky position, so you just want to roll it at the short rate. That way the loan will never change in value. All it does is enable the position in the 30-year bond.
Your next question is how will you get the loan? The answer, of course, is that you’ll use whatever collateral allows you to get it the cheapest. Maybe there’s strong demand in the repo market for a 10-year bond in your portfolio (short sellers really want to sell that bond) today. So you use that bond as collateral for your repo loan which you get at a really low rate. Maybe tomorrow it will be some other bond, and you’ll use that. The point is that there is no relationship between any one asset in your portfolio and your financing method.
So repoing an asset is used as a way to increase, not decrease your exposure to that asset or some other assets you want to own. This seems like the exact opposite of your hypothesis that repo is used as a substitute for selling the asset; it’s used as a way to buy more.
On the other (reverse repo) side of the repo trade there are variety of closely related motivations for entering into the trade. The common principle is that someone who is lending overnight against collateral achieves relatively less market risk. A bank who has received net reserves during the day needs to unload those reserves and faces the choice between buying risk assets from a bank in a deficit position or just lending that bank the reserves using those risk assets as collateral. So the GC loan is a way for them to reduce their risk and allowing the deficit bank to increase theirs. The special bond repo trade is similar, though not as simply explained by standard portfolio theory. People want to borrow particular bonds because they want to be short bonds. They may be credit traders, market makers in bonds or derivatives, inflationistas, gold bugs, Republican members of congress, whatever. But shorting bonds is just another version of “wanting less market exposure.” So the repo trade is always a case of the borrower (collateral lender) wanting to get more market exposure and the lender (collateral borrower) wanting to get less.
I can’t think of any case in which a market participant would borrow an asset in order to gain exposure to it. On the contrary.
I guess the question from the back of the class was quite interesting.
Hope I can contribute to the debate, even with null knowledge of financial economics. I apologize in advance for any confusion in the equations which is more than likely.
1) The profit that the pawn shop will receive is S(t)r (where I abstract from the haircut) s the spot and r the agreed net rate. Now, if you would sell your watch and buy a future(assuming homogeneous watches)the abstract counter party of this trade would receive F(t)-S(t+1). So doing a repo the pawn shop does not bear any risk(assuming no default), while doing the trade in the market the abstract counterparty is bearing the risk.
For risk averse(and profit maximazing) pawn shops F(t)-E(S(t+1))>S(t)r and let d denote the positive number that makes the inequality an equality(similar to a risk premium), F(t)-E(S(t+1))=S(t)r + d. The expected value of your portfolio with repo is E(S(t+1))-S(t)(r) and the expected value of your portfolio with the market trade is S(t)+E(S(t+1))-F(t), thus (ii)Valuerepo-Valuemarket = F(t)-S(t)(1+r), then substituting(i) in to (ii) Valuerepo-Valuemarket= d + E(S(t+1))-S(t). So a repo is convenient as long as the
pseudo risk premium (‘d’) can compensate the expected drop in value of your asset (of course for appreciation is always convenient). I find this quite intuitive because considering that you always end up with the watch in the market process you are able to re-buy it for a lower price, whilst in the pawn shop you cannot internalize in the deal this drop. And the reverse with appreciation if it is expected the future price will be more expensive (internalizing the expectation) whilst the repo deal remains unchanged to your advantage.
2) Depending on the collateral required for a future if it is more liquid (and you precisely seek liquidity) or bigger than the haircut you will prefer to do a repo.
Congratulations on this blog, one of the best to learn economics. I hope you find this ideas useful!
PS: Shouldn’t we know all this things that you ask as economists before knowing dynamic programming or Matlab?
Ritwik,
“a repo transaction converts a 30 day t-bill into an overnight loan.”
I’m not sure exactly what you want to say, but I definitely wouldn’t put it that way (I hope I didn’t!). If you use a t-bill to get a repo loan, then economically you have a t-bill and a repo loan. You still have the t-bill and are exposed to the full economic consequences of ownership (even if technically it’s not yours for the next 24 hours). So you haven’t exchanged it for overnight risk.
The point of using the t-bill to obtain a loan has nothing to do with how you feel about the t-bill. You do it because it happens to be the cheapest way of obtaining your desired financing (leverage).
Nick,
To respond to your earlier question:
Michael: So bond dealers “borrow” their inventory of bonds? OK, that makes sense. But the stock of bonds in dealers’ inventory must be a very small percentage of the total stock of bonds, no? And if this were the only source of the repo market, we presumably couldn’t talk about a ‘shortage of safe assets for repos”. Because presumably if the total stock of bonds shrank, dealers’ desired inventories would shrink too, roughly in proportion.
Bond dealer inventories are trivial compared with the amount that is bought and sold, borrowed and lent, in the bond markets, by dealers, hedge funds, treasury areas, ETFs, etc They all have access to the trading and lendin markets. Bonds cycle multiple times through the clearing system on a given day. There are trillions in face value of daily trades trades for billions in bond issuance and a trivial amount of dealer “inventory”. Dealers typically do not maintain an inventory of bonds at all. They just try to capture a modest spread to fulfill customer orders, and hedge customer trades in real time. If a given bond has a small issuance, it may be harder to borrow, all else equal, and the repo rate specific to that bond may reflect these supply conditions. The “special” repo rate will eventuall be low enough to induce some porfolio owner of the bond to lend it out. During the Clinton- era US surplus, when bond issuance was smaller, you often had to lend money at zero in exchange for borowing scarce 10- year notes. I have no insight at all into the question of the sufficiency of “safe bonds” in the context of the current financial crisis.
Nick: “Yep, but aren’t there transactions costs of doing a repo too? Why does a repo have lower transactions cost then the separate sale and purchase?”
Purchases and sales come with brokerage fees and one is subject to the bid-ask spread.
Treasury repos — at the very least — eliminate the bid-ask spread. Often times the haircut is near zero. Even the haircuts on structured debt products were near zero prior to the financial crisis. See Gorton and Metrick: http://research.stlouisfed.org/publications/review/10/11/Gorton.pdf
K
“The point of using the t-bill to obtain a loan has nothing to do with how you feel about the t-bill. You do it because it happens to be the cheapest way of obtaining your desired financing (leverage).”
Athough the fact that you’re financing it at all (at the margin) does say something about how you feel about the bill.
From there, it’s a choice as to the best financing method.
And in fact repo may be the only alternative that’s cheap enough to cause you to hold onto the bill in the first place.
Unless you’re otherwise constrained to hold onto the bill.
acarro: MM by itself is indeed useless for any practical purpose, and I would much prefer an experienced practitioner over MM. MM is like a purely negative result. But MM revealed that the practitioners’ understanding must rest on some implicit assumptions, that perhaps were hidden to the practitioners themselves. Maybe, by thinking about MM, and trying to figure out what those implicit assumptions are, practitioners could improve their understanding, and adjust in different circumstances, depending on cases where those assumptions were or were not true. Or maybe, they would find that their implicit assumptions were in fact always true, so they didn’t have to change what they thought, and the only benefit is that they have the satisfaction of knowing that their understanding is now built on a deeper foundation.
My head hurts. I mean literally this time. Probably because I was crawling under the MX6 last night trying to replace the oil pressure sending unit. I may take a break.
Nick: If banks did repos under one accounting convention, and didn’t do repos under a different accounting convention, then someone is being fooled somewhere, and that’s the motive for repos
What is your understanding of why people have conventions? Looks like you call it fooling and therefore harmful.
Yes, there are different accounting rules. Some assets are held for mark-to-market purposes in trading book (say gold), some assets are held for income purposes in banking book (say loans, bonds) and some assets are just assets and simply used/consumed (amortized) in the process (say land/buildings). Accounting rules require you to define your business model for each of your business lines. Large number of numbers as per your definition? The definitions of business models allow accountants to cut this large number down to just a few numbers. But what is the problem with it?
Is it that all you are puzzled about is why everybody does NOT use market values in accounting process? Because if it was the case then most likely there would be no need and market for repos. But then your argument is completely different from the whole discussion above.
Is it all you are puzzled about?
Re the disc. with Ashwin:
Repo’s allow a party to engage in maturity transformation; selling bonds for cash does not. The purpose of the repo mkt during the 2001-2007 shadow bank growth was not to finance trading positions (that earn money through market making), but to finance maturity transformation of AAA or AA rated (quasi riskless) securities.
As Carolyn Sissoko has written (Synthetic Assets blog), a system more reliant on unsecured lending is less coupled, better able to weed out lemons, and therefore more robust. The chart below gives an indication of how far some E. banks have gone in terms of encumbering their assets: in an unsecured lending market they arguably would have failed long ago. Now, if they fail the value of their collateral will also tank. This is the inherent “tight coupling” of a collateralized banking/shadow banking system.https://twitter.com/tracyalloway/status/233201834234363904/photo/1/large
I think that you hit the idea a while back with transaction costs and risk shifting. As Bob Smith and others have noted, there a variety of “transaction costs” including tax, accounting, and bankruptcy-related issues.
Yes, a repo is equivalent to a set of transactions (but now, sell forward, etc). Please can and do sell bonds forward. However the point you are still missing I think is that each bond is idiosyncratic. there are reasons one might need a very specific bond to hedge some risk. The demand for a very specific bond may be greater than supply, hence the need to create essentially a derivative transaction (a repo).
Just to clarify a point which K has also made which may not be obvious to all – the initial “seller” in a repo transaction retains all the economic benefits and risks of the underlying instrument. A repo is a “sale” only in the legal sense so as to allow the “buyer” to liquidate the asset on default and avoid having to go through bankruptcy proceedings. In the economic sense, it is secured lending (which is obviously cheaper than simple secured lending due to the legal benefits of being treated as a sale).
So obviously this is not equivalent to a sale today and a purchase tomorrow or vice versa if both are made at then-current market prices because in this case you are not economically exposed to the asset as a seller in the interim 24 hours. If I decide the market prices in advance, then it is just a secured loan with some legal benefits.
And here’s a link to the book by Moorad Choudhry
^^ “(but now, sell forward, etc). Please can can do sell forward”
ugh: should be “(buy now, sell forward, etc). People can amd do sell forward”
Nick,
To respond to your earlier question, “Michael: So bond dealers “borrow” their inventory of bonds? OK, that makes sense. But the stock of bonds in dealers’ inventory must be a very small percentage of the total stock of bonds, no? And if this were the only source of the repo market, we presumably couldn’t talk about a ‘shortage of safe assets for repos”. Because presumably if the total stock of bonds shrank, dealers’ desired inventories would shrink too, roughly in proportion.”
Bond dealers keep trivial inventories compared to the size of debt issuance, and the size of debt issuance is trivial compared to the size of daily bond purchases and sales, borrowing and lending. The most traded bonds cycle hundreds of times through the clearing system in a single day. Big players have netting agreements that allow them to deliver/ receive only the net position for a given bond on a given day. Many players, including hedge funds, insurance companies, government agencies, corporate treasury areas, ETFs and public funds have direct or indirect access to the repo market, and can be a source of securities for lending. In fact, for some of the afore mentioned classes, repo is a cheap source of finance for their inventories.
If a particular bond has a small issuance size, then all else equal it will be harder to borrow, and the bond- specific repo rate will reflect that scarcity. The short positions in a bond (whether resulting from bond sales or uncovered bond lending) need to buy or borrow the collateral from those who own or have already borrowed it. So the shorts offer to lend money against the collateral at a low rate. In the US, the FED will induce shorts unable to cover in the repo market to buy back the bonds, in order to maintain an orderly market. A “failure to deliver” is economically like a repo at a zero rate, but brings the added odium of regulatory displeasure. The impact will be lower bond yields for the scarce bonds, all else equal, since their purchase can be financed, for some period of time, until the squeeze unwinds, for free or near free. No different than q stock squeeze.
I have no insight at all on the “scarcity of safe bonds” in the context of the current financial crisis. I am just discussing conventional repo mechanics.
JKH,
“And in fact repo may be the only alternative that’s cheap enough to cause you to hold onto the bill in the first place.”
Agreed. Unless you’re a leveraged player, you’d think you’d never own that issue. Of course, the weird thing is that real money investors buy on-the-run bonds that trade special all the time. The only justifiable reason is that they are huge and they need liquidity and “specialness” tends to coincide with liquidity for the reason that the shorts really value liquidity too.
But it is crazy to buy a special bond and not repo it, which is why lots of large pension funds have the ability to use repo: i.e. they repo the bond and use the proceeds to buy higher yielding short term paper. (And hopefully they are smart about it…)
Ashwin: Exactly.
Yes the bankruptcy issue… In the US repos are the only kind of lending not subject to a stay upon bankrupcy. As such repos are the most senior of all possible loans. It was Volcker who got this codified as law after a bankruptcy judge treated some repos as loans instead of sales. So the law says they are sales…
This is outside the relm of govt bonds, but maybe it will add something to the discussion about why a repo market exists:
I’ve been in the business of purchasing super risky bonds. As a condition to making these purchases I often demanded leverage from the seller (if a bank). Repo was typically the compromise between the ideal borrowing I wanted (long term, no mark to market, cheap) and what the bank wanted (no lending against the asset at all). It was not clearly an attractive risk proposition for the bank; repo was mainly provided to entice asset buyers and shed assets.
Ashwin: “So obviously this is not equivalent to a sale today and a purchase tomorrow or vice versa if both are made at then-current market prices”
True, but it would be equivalent to a sale today and purchase tommorrow at the current market price through a forward purchase agreement entered into today – as you point out, legally, that is what a repo is (albeit with one counterparty, rather than two). In that example, the seller retains the economic exposure to the underlying bond. I wonder how the accountants would record that transaction on the books of the seller?
MP,
“repo was mainly provided to entice asset buyers and shed assets”
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.
You’ll like this Nick…
Think of a pure exchange economy. Party B wants to obtain a certain risk asset, and party A wants to get rid of it. But there’s no double coincidence of wants, because B doesn’t have anything of equal value that A wants in exchange, so they can’t complete the trade. The only way they can complete the trade is for A to lend B the value of the asset. The loan exactly offsets the purchase, so no medium of exchange is required (just a unit of account). But since A doesn’t trust B, A must hold the asset as collateral. Every day they renew the loan at the new, current rate of interest. If, one day, A decides to stop lending to B, B must immediately sell the asset back to A at the spot price on that day. So B has the full economic risk of the asset as long as the arrangement continues. A, on the other hand, has replaced the asset with savings at the risk free short rate.
Looking over the comments, I mostly see convoluted forms of, “Yeah, two and three are basically right.”
Makes sense.