For 20 days straight, the US Federal Reserve has been quietly bailing out banks (again!) — to the tune of hundreds of USD 1.5 TRILLION of dollars.

by Lumyai

Why the Repo Market Is Such a Big Deal—and Why Its $400 Billion Bailout Is So Unnerving

One of the most vital pieces of plumbing that powers the global financial system usually runs so smoothly that it gets overlooked by market watchers. It’s the “repo market,” comprising the short-term funding that banks and financial counter-parties regularly tap to lend each other trillions.

It’s suddenly in the news again, and for all the wrong reasons. The repo market is looking a lot like it did on the precipice of the 2007 housing market crash.

But what is the repo market, anyway, and why has the Federal Reserve Bank this week injected hundreds of billions of dollars into the financial system to stabilize it?

Repos (short for repurchase agreements) are short-term borrowing transactions, often made overnight. Think of them as trades of cash for some kind of collateral.

In a repo transaction, the borrower will sell certain securities in their possession with the agreement to buy them back the next day. If the transaction is not rolled over, then the trade has to be settled the following day, with the borrower repurchasing the collateral from the lender for slightly more than it had previously sold it for, compensating the lender with interest for taking on the risk.

A $1 trillion market springs a leak

Large corporations and banks typically hold vast quantities of highly liquid financial assets, and so they like using these markets as a means of quick and easy financing. In fact, there are more than $1 trillion worth of overnight repo transactions collateralized with US government debt occurring every day. Banks frequently go to these markets to fund the loans they issue, and to finance the trades they execute.

That’s when it’s working smoothly.

The repo market seized up last week, with median repurchase rates skyrocketing from their usual band of 2.00-2.25% to 2.46% on Monday, and 5.25% on Tuesday. Keep in mind, that’s the median rate. Some repo rates were as high as 9%, more than quadruple the Federal Reserve’s own target rate, which usually puts a cap on how high Treasury repo rates could climb.

An unlucky confluence of events, including an exceptionally large demand for cash from U.S. companies that needed to pay their corporate tax bills, sucked a lot of the available cash out of the financial markets. What happened last week was any counter-party in need of cash, and only holding collateral like Treasuries, agreed to pay the much higher going repo rates. That’s supply and demand, plain and simple, and it mirrors what happened in certain repo markets in 2007 before the housing crash and the Great Recession that followed.

So, what happened to the usual abundance of cash and liquid securities that powers the trillion-dollar repo market?

It’s been slowly evaporating, actually, for some time, since the Fed ended five years ago the policy of quantitative easing (QE), its maneuver to buy highly liquid bank securities to boost overall bank reserves. The thinking (and hope) of that controversial policy was that the increased liquidity would encourage banks to lend more and spur economic growth at the depths of the downturn.

877 views