Thursday, October 17, 2013

Where Does the Fed's Stimulus Money Go? Part 3

Where Does the Fed's Stimulus Money Go? Part III The Repo Man

By Dr. Van Tharp Trading Education Institute

I had a most interesting conversation over lunch yesterday with a modern day “repo man” where he talked about one of the least well-known activities in the financial markets — securities repurchases, known broadly within the industry as a “repo.” I mentioned that folks like him doing repos probably have an identity crisis since the term repo has another connotation in the work-a-day world, and the bond repurchaser sitting across the table readily agreed!

Ask a person on the street what a “repo” is and most will call to mind the off-beat, black Sci-Fi comedy Repo Man starring Emilio Estevez. The movie depicts, in Hollywood fashion, the life of a young punk rocker that has lost his way and finds a career repossessing cars whose owners have fallen behind on their payments. (Another movie of the same name from 2010 starring Jude Law and Forest Whitaker follows a very different premise/plot and has not reached the “cult classic” status of the 1984 film.)

As mentioned above, in the financial world, the term “repo” is shorthand for a repurchase or, more correctly, repurchase agreement. Repos are very common and important activities that allow institutions to generate short-term cash using less liquid securities as collateral.

In essence, a repo functions like a loan backed by collateral with the key distinction that the collateral actually changes hands. In simplified terms, it works like this: the owner of non-liquid securities (e.g. corporate bonds or any security with longer term hold periods) will sell that asset to an ersatz lender in exchange for cash with the agreement to repurchase the asset at a later date.

Because the entity providing the cash actually takes control of the asset (so they can sell them to a third party or at least use them as collateral for other transactions), the transaction costs of the “loan” can be quite small, making this a very efficient transaction. Hence it is a low cost way for companies to generate short term cash or cash from “idle” assets.

In terms that my third grade economics students would understand, repos are a bit like the finance world’s pawn shop — things with value but no liquid market (like the ruby encrusted gold broach you inherited from Aunt Mabel) can be turned into cash. (Thanks to my good friend CRC for this analogy!) In the same way, everything from long maturity treasuries to dusty old corporate bonds sitting in the corner of the vault and just taking up space are turned into short-term cash by using the repo system.

Coming to a Bank Near You: the Reverse Repo

In the first article in this series, we talked about one of the unintended consequences of QE — the reduction in high quality collateral on bank balance sheets. In essence, the Fed has been buying up high quality collateral (treasury securities) and replacing them on bank balance sheets with reserves held at the Fed; reserves that can only be traded among banks and NOT with third parties. This action, along with higher perceived risks, have reduced the repo market considerably since the Great Recession:

This reduction in repo transactions has contributed to the reduction in the velocity of money in the broad economy. The velocity of money is one of ways that we measure the amount of “lubrication” in the market — how easy it is to transact commerce. For that reason, this chart on velocity is well worth repeating:

The collective effects of dwindling amounts of high quality collateral, reduced repo transactions, and contracting velocity of money means that sooner rather than later, the Fed (and other central banks) will have to start unwinding the huge amount of reserves they have created over the last five years.

Next week, we’ll dig into the “reverse repo” transactions that many in-the-know players expect the Fed to use and why it’s important for traders and investors to understand this arcane bit of financial alchemy.

Until then, your thoughts and comments are welcome, click here to send them to us.

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