The Repo Market - New York University
Debt Instruments and MarketsProfessor CarpenterThe Repo MarketOutline and Readings Outline RepurchaseAgreements (Repos) The Repo Market Uses of Repos inPractice BuzzwordsRepo, Reverserepo, Repo rates,Collateral, Margin,Haircut, Matchedbook, Special Suggested reading Veronesi, Chapter 1 Tuckman, Chapter 15 Pozsar, et al., Shadow BankingThe Repo Market1
Debt Instruments and MarketsProfessor CarpenterRepos We often talk about buying and shortingsecurities. In the fixed income market, thesetransactions are accomplished with the useof the repo market. A repurchase agreement, or repo, is a saleof securities for cash with a commitmentto repurchase them at a specified price ata future date. Practically, the repurchase agreement byitself is simply a collateralized loan.Repo DiagramCounterpartyDealerBorrow moneySettlementdateEnd of termLend securities(collateral)Pay back money interest at reporateTake backsecuritiesThe Repo Market2
Debt Instruments and MarketsProfessor CarpenterExampleDealer repos 30 million par of a Treasury bond to amunicipality for 51 days. The market value of the collateral is 31,228,715. The municipality takes a 2% haircut, lending 98%of the market value, or 30,604,140.70 at a reporate of 5.25%. After 51 days, the municipality returns the 30million bonds, and the dealer repays 30,604,140.70 (1 0.0525 x 51/360) 30,831,759. Note that repo rates are simple interest rates thatuse an actual/360 calendar (in the U.S.--someother countries use actual/365).Reverse Repo A reverse repo transaction is essentially justthe other side of a repo transaction. However, the labels are determined fromthe dealer's viewpoint, so if the dealer borrows money, it's a repo if the dealer lends money, it's a reverserepo.The Repo Market3
Debt Instruments and MarketsProfessor CarpenterTypes of Collateral Treasuries Agencies Mortgage-backed securities Even corporate bonds, equity, or custom collateralGood Security Design The repo market provides an excellent form ofcollateralization Inexpensive financing for security holders Relatively safe loans for short term investorsAverage Daily Outstanding,in Billions, 1996-2010Financing by U.S. government primary dealers involving U.S. government,federal agency, corporate and federal agency MBS securities. Source: SIFMA.The Repo Market4
Debt Instruments and MarketsProfessor CarpenterTypical MarketParticipantsCash ProvidersMoney Market Mutual FundsInsurance CompaniesCorporationsMunicipalitiesCentral BanksSecurities LendersCommercial BanksSecurities ProvidersSecurities LendersHedge Funds /Levered AccountsCentral BanksCommercial BanksInsurance CompaniesTerm of the Loan If the duration of the loan is one day, theagreement is called an overnight repo.* Approximately 50% of the market. Otherwise the agreement is a term repo* The term can be as long as one year.* The vast majority of repos have maturitiesof three months or less. Open repo is an overnight repo whoseterm is renegotiated on an ongoingbasis.The Repo Market5
Debt Instruments and MarketsProfessor CarpenterCredit Risk in RepoFor example, suppose a school district enters into a 10mm 30-day repo with a low capitalized dealer. The dealer delivers 10mm worth of a T-Note. If the dealer is forced into bankruptcy and cannotrepurchase the T-Note, then the school district mustsell the collateral in the open market to get itsmoney back. However, if the market has dropped, then thedistrict will suffer a loss. Both parties are subject to credit risk, because themarket value of the collateral can change during thelife of the loan. The Repo Market6
Debt Instruments and MarketsProfessor CarpenterWays of reducing thecredit exposure Margin (Haircut) Lenders often require a margin, orovercollateralization to limit their credit exposure(typically 1% to 3% for high grade collateral, butcould be as high as 50% for some kinds ifcollateral). Mark to Market on a regular basis If the collateral value changes by too much,collateral levels or loan balances are adjusted. 1992: the first global master industry standardrepurchase agreementUses of Repos in Practice:Financing a Long Position Dealers do not own all their inventoryoutright. They can finance the purchase of a Treasuryby simultaneously entering into a repo usingthe same Treasury as collateral. Note that this amounts to a forward purchaseof the Treasury: establishing a long positionin bonds with no cash up front. This is an easy way to execute a levered beton bond prices rising.The Repo Market7
Debt Instruments and MarketsProfessor CarpenterOpen marketLONG POSITIONREPODealerCustomerbuys securitiesworth P0Receive collateral ofsecurities worth P0Time 0pay P0lend P0 x (1 - hc)Time 0 cash flow to dealer -P0 x hcsell securitiesTender back collateralTime Treceive PTGetP0 x (1 - hc) repo intTime T cash flow to dealer PT - (P0 x (1 - hc) repo interest)Time 0 cash flow Time T cash flow PT - P0 - repo interestUses of Repos in Practice:Short positionsSuppose a dealer wants a position that willprofit if bond prices decline. He can simultaneously enter into a reverserepo and sell the collateral. He borrows the bond and sells it, using theproceeds of the sale to lend into the reverserepo. At the end of the term of the repo, his loan isrepaid with the agreed upon interest, and hebuys the bond back in the open market todeliver into the reverse repo. The Repo Market8
Debt Instruments and MarketsProfessor CarpenterUses of Repos in Practice:Running a Matched Book The dealer may simply act as a marketmaker, or intermediary, entering into repotransactions with some counterparties, andoffsetting reverse repos with others. The dealer’s compensation is that thereverse repo rate (the dealer’s lending rate)is typically about 5 basis points higher thanthe repo rate (the dealer’s borrowing rate).Two Repo Markets General Collateral: this market is about themoney – investors lending money to securitiesholders Specific Issue: this market is about the bonds –getting and giving possession of specificsecuritiesThe Repo Market9
Debt Instruments and MarketsProfessor CarpenterDeterminants of theRepo RateThe repo rate varies withthe quality of the collateral (agencies andmortgages may also serve as collateral inaddition to Treasuries), the term of the loan, and the nature of the delivery of the collateral. Ifthe lender requires delivery of the collateral,he may get a lower rate than if he allows thecounterparty to merely place the collateral ina separate account at his bank. Special Repo Rates Sometimes certain Treasury bonds go on special. Current issues are often on special. A short squeeze in which a lot of dealers whohave shorted a particular bond need to covertheir short positions can cause the issue tobecome special. Reverse repos provide the dealer an opportunityto borrow issues on special. In that case, the issue commands a specialrepo rate below the repo rate for generalcollateral.The Repo Market10
Debt Instruments and MarketsProfessor CarpenterPricing: Specific Issues/Specials Supply Total Issuance Size Lendable/Nonlendable Supply Re-openings/Buybacks Distribution of Supply Demand Overall Size of Short Base Distribution of ShortsThe Repo Market11
Debt Instruments and Markets Professor Carpenter The Repo Market 6 Credit Risk in Repo For example, suppose a school district enters into a 10mm 30-day repo with a low capitalized dealer. The dealer delivers 10mm worth of a T-Note. If the dealer is forced into bankruptcy and ca
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Finally, the article presents an analysis of a repo squeeze, in which a repo trader with market power chooses the optimal mix of funding via a triparty repo and funding directly in the repo market. Two appen-dixes provide additional analysis on the term struc-ture of repo spreads and on how repo rates affect the
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