Repurchase Agreements, Repo Market Risks, and Their Regulations
How Big Banks Could Blow Up the Economy Again
A repurchase agreement, or repo, is a short-term loan. Banks, hedge funds, and trading firms exchange cash for short-term government securities like U.S. Treasury bills. They agree to reverse the transaction. When they hand back the cash, it's with a 2 to 3 percent premium. The repo exists overnight, but some can remain open for weeks.
A repo transaction is a sale that's treated in the books like a loan. The seller keeps the security on its books, adds the cash received to its assets and adds a loan to its liabilities. It's an easy way to raise cash quickly.
The most common type of repo is the tri-party agreement. Big commercial banks act as the middle-man, between a hedge fund that needs cash and a money market fund that would like a relatively safe boost to its return.
Risks in the Repo Market
Around the world, companies hold almost $5 trillion in repos on any given day. Even though this is less than the $6 trillion held in 2008, it creates a huge demand for short-term bonds.
U.S. Treasury bills are used for $2.4 trillion in repo trades. Many analysts worry there aren't enough to keep the repo market running smoothly.
The demand for these bonds is coming from:
Hedge funds are a real worry for the repo market because they never know when they're going to need a lot of cash quickly to cover a bad investment. These funds try to outperform the market by using risky derivatives and options, such as short-selling a stock. When their investments go the wrong way, and they can't get enough cash quickly to cover them, they suffer huge losses. That can take the market down with them.
An example of what can happen is the October 2014 flash crash when the yield on the 10-year Treasury note plummeted in just a few minutes. Some Federal Reserve bank presidents are concerned that banks, like Goldman Sachs, have started reducing their repo business. That makes it more difficult for the hedge funds to get the cash they need to cover investments. This could create instability in the financial markets, making credit more expensive and difficult to get just as the economy is picking up steam.
Regulation of Repos
The Dodd-Frank Wall Street Reform Act regulates hedge funds owned by banks, making sure they don't use investors' money to make deals for themselves. Other hedge funds are now regulated by the Securities and Exchange Commission.
The Fed has required banks to hold a larger amount of securities on hand to secure these risky short-term loans. This is one reason banks are cutting back on that side of their business. It's ironic that this regulation, designed to reduce volatility, is actually creating more. But the Fed said it's worth it because financial markets were too dependent on short-term lending in the past.
Fed members warn that hedge funds should be required to keep more of their own cash on hand to cover these losses, instead of relying so heavily on the repo market. The Fed and the SEC must work together to develop the same set of standards for the hedge funds they oversee. Foreign regulators must be included, as well. Otherwise, U.S. companies will have higher costs and be at a competitive disadvantage.
Regulations may be inadvertently adding risk to the repo market by discouraging banks from being in the business at all. The largest U.S. banks have reduced their repos by 28 percent over the last four years. To fill the void, real estate investment trusts and other unregulated financial firms are either issuing the repos directly or acting as middlemen. This worsens the liquidity problem in the bonds that underwrite the repos.
The Federal Reserve started issuing reverse repos as a test program in September 2013. Banks lend the Fed cash in return for holding the central bank's Treasurys overnight. The Fed pays the bank a little extra interest when it buys the Treasury back the next day.
Why is the Fed doing this? It certainly doesn't need to borrow cash to cover risky investments. Instead, it's trying out a new tool to guide short-term interest rates. This way, it doesn't have to announce it's raising the fed funds rate, which depresses the stock market.
The Fed program is very successful so far. Banks shifted a record $242 billion from the private Treasury market onto the Fed's books. In fact, it may be too much of a good thing. The Fed now issues more reverse repos than anyone else. That's one reason Goldman Sachs and others are cutting back their programs.
And actually, that's what the Fed wants. It has long desired a greater ability to regulate this market. Its larger role is giving it more influence than new laws ever could.
Did Repos Contribute to the Financial Crisis?
Many investment banks, like Bear Stearns and Lehman Brothers, relied too heavily on cash from short-term repos to fund their long-term investments. When too many lenders called for their debt at the same time, it was like an old-fashioned run on the bank.
First, Bear Stearns and later Lehman couldn't sell enough repos to pay these lenders. Soon, no one wanted to lend to them. It got to the point where Lehman didn't even have enough cash on hand to make payroll. Before the crisis, these investment banks and hedge funds weren't regulated at all.
Some researchers disagree. A Northwestern University study found that 90 percent of the repos were backed by ultra-safe U.S. Treasurys. Furthermore, repos only made up $400 billion of the $2.3 trillion in money market fund assets. The researchers concluded that the cash crunch occurred in the asset-backed commercial paper market. When the underlying assets lost value, the banks were left with paper no one wanted. It drained their capital and caused the 2007 banking crisis.