The $3 trillion daily Repo market isn’t usually on the investors’ radar until the Repo market blew-up in mid-September when the Repo rates spiked to 10%.
For the financial system, the severity of a sharp rise in the cost of a $3 trillion short-term lending market is similar to a major electrical substation of the city failing. A crisis in the Repo market would spread to other tentacles of the financial system, with the flow of capital eventually grinding to a halt.
So the Repo market is on the Fed’s radar
Moreover, the Fed frequently enters the market deciding whether to inject or pull out cash from the market to allow the Repo market to return to normal.
What then is this little known yet sizeable and highly important Repo market?
The Repo Market is a short term for the repurchase agreement market.
In a few words, this is an overnight cash and collateralized asset exchange facility. Put simply, it is a market for short term funds which financial entities use to purchase collateralized assets. The Repo market also provides short term liquidity to banks to fund their day to day operations.
Why did the Repo market rate spike to 10% in September?
The law of market dynamic is at work when the demand for short term cash exceeds the supply of available cash, then the short term interest rate will spike. A sudden change in market conditions disrupts capital flows, which can also increase demand for short term cash, thereby causing the Repo rates to spike.
Who relies on the Repo market?
Bank are net lenders to the $3 Trillion Repo market because they can source less expensive finance elsewhere. However, a situation can and does arise when a bank’s day to day lending activities results in its cash reserves falling below a permitted level. Banks are required to keep certain amount of cash reserves overnight. So to make up for any shortfall in liquidity the banks turn to the Repo market for short term finance. In this case, the bank will seek out a cash facility, where they will pledge collateral, usually Treasury bills for short term cash.
The Repo market is an important component of the capital market, which provides short term liquidity
Other financial firms are more reliant on the Repo market for their source of short term funds to finance their speculative bets.
For example, hedge funds, private equity firms, real estate investment trusts are all net borrowers in the Repo market. For these financial firms, the Repo market is the cheapest source of funding.
The Repo market is a cheap source of finance for hedge funds, private equity firms, real estate investment trusts and to a lesser extent banks
How then is the Repo market an important piece of the profit pie for hedge funds and investment trust?
These entities borrow short term in the Repo market and then they invest the cash in long term investments in a highly leveraged way. For example, a real estate investment trust invests in long term assets, such as mortgage-backed securities, which are guaranteed by government-sponsored enterprises. They also buy collateral loan obligations, single security backed by a pool of debt often corporate debt.
These group of investors funds their purchases in the Repo market.
Moreover, their profits are derived from the difference between the high yields of the mortgage-backed securities, and the low cost of borrowing in the Repo market.
So these investors aim to create profits by leveraging their investment in long term higher-yielding securities financed with relatively cheap interest rates in the Repo market.
But when Repo market interest rates suddenly spike much higher as they did in mid-September, these actors then have unprofitable business models overnight. Put simply, $3 trillion daily Repo market seizes up.
So a major component of the financial system, the Repo market interest rate is sensitive to the changing market demand for short term cash.
How does the Fed intervene in the Repo market to tame Repo interest rates?
The Fed swiftly responded to September’s Repo madness by zeroing in its endless firepower on treasuries with less than a maturity date of one year.
Since the Repo market blowout in September the Fed has actively been buying Treasuries with maturities of less than one year, the Fed does this to push up the amount of excess reserves held at banks to get control of the Fed fund rate and the Repo rates.
The Fed balance sheet through October 30 included $215B in Repos, which went from zero a few months ago. Also, the Fed started buying treasury bills to the amount of $51B.
The Fed’s balance sheet has expanded by $260B of assets in just 2 months, which is far larger than QE2 and QE3.
What impact is the Fed’s QE having on the Repo market?
When the fed targets the short end of the curve, through its purchases, it lowers the Repo interest rates.
Who benefits from the lower Repo interest rates?
The Fed is maintaining the status quo when it targets the short end of the yield curve, through asset purchases. So the Fed is ensuring that the high leverage game continues, the game of borrowing short term and betting long term on leveraging financial speculations. Private equity firms, real estate investment trusts are the big winners of the Fed’s massive Repo market intervention.
If the Repo rates go to say over 5%, most of these companies start making losses and they would no longer be able to fund their operations and leveraged bets.
Take, for example, AGNC Investment, a real estate investment trust, which lists $106B in total assets, according to its latest filing with the SCC.
The company has $10B in equity capital and is highly leveraged and financed through the Repo market, on June 30 AGNC owed $86B to the Repo market and nearly all of its cash to fund its operations comes from the repo market. The company paid a weighted average interest rate of 2.6% on $86B on its borrowings.
But AGNC Investment prudently betted that the Fed would enter the Repo market if rates shot to 10% and the bet paid off.