Repurchase Agreement -Introduction

• A repurchase agreement or repo is a contract in which a security is traded at some initial price with the understanding that the trade will be reversed at some future date at some fixed price.

• Repos are short-term contracts that are used to lend money on the security of usually high- grade collateral, to finance the purchase of bonds, and to borrow bonds to be sold short.

• Financial institutions have traditionally relied on repos to finance some portion of fixed income inventory. Repo financing, as secured, short-term borrowing, is typically a relatively inexpensive way to borrow money.

• However, the practice can leave firms in a perilous situation. This can happen if lenders of cash through repos, in times of trouble, fail to renew their loans. This turned out to be an issue in the financial crisis of 2007-2009.

Repurchase Agreement – Structure

• In the above diagram, counterparty A is borrowing $1,000,000 from counterparty B. In a repo transaction, this is achieved by A selling an asset to B. Lets say the interest rate of the loan is 12% per annum.
• Now, it is decided that A will repay the loan to B in 2 month’s time (with the accrued interest). This will be achieved by A buying back the asset from B at the end of 2 months at the price of $1,012,000. This amount is reached by adding the interest accrued in 2 months (i.e. $12,000) to the amount at which A had sold the asset in the first place (which is $1,000,000)

Uses of Repos – Cash Management

• Investors holding cash for liquidity or safekeeping purposes often find investing in repo to be an ideal solution.

• The most significant example of this is the money market mutual fund industry, which invests on behalf of investors willing to accept relatively low returns in exchange for liquidity and safety.

• A money market fund would lend money while taking collateral and then, at maturity, collect the loan plus interest and return the collateral.

• Holding collateral makes the lender less vulnerable to the creditworthiness of a counterparty because, in the event of a default by one of the counterparties, the other counterparty, in this case the money market fund, can sell the repo collateral to recover any amounts owed.

• In summary, relative to super-safe and liquid non-interest-bearing bank deposits, repo investments pay a short-term rate without sacrificing much liquidity or incurring significant default risk.
• Municipalities constitute another significant category of repo investors. As the timing of tax receipts has little to do with the schedule of public expenditures, municipalities tend to run cash surpluses from tax receipts so as to have money on hand to meet expenditures.

• These tax revenues cannot be invested in risky securities, but neither should the cash collected lie idle. Short-term loans backed by collateral, like repos, again satisfy both revenue and safety considerations.

• Other institutions with similar cash management issues that choose to invest in repo are mutual funds, insurance companies, pension funds, and even some nonfinancial corporations.

• It is worth noting, however, that many lenders in the repo market during the recent financial crisis realized that they were not well positioned, either in expertise or operational ability, to take possession of and liquidate repo collateral.

Uses of Repos – Long Financing

• Financial institutions are the typical borrowers of cash in repo markets. Say that a client wants to sell €100 million face amount of the 𝐷𝐵𝑅 4𝑠 of January 4, 2037, to the trading desk of a financial institution. The desk will buy the bonds and eventually sell them to another client.

• Until that buyer is found, however, the trading desk needs to raise money to pay the client. Put another way, it needs to finance the purchase of the bonds. Rather than draw on the scarce capital of the financial institution for this purpose, the trading desk will repo or repo out the securities or sell the repo.

• This means that it will borrow the purchase amount from someone, like a money market fund, and use the 𝐷𝐵𝑅 4𝑠, which it just bought, as collateral.

• When the bonds are ultimately sold to some buyer, the desk will unwind the repo, using the proceeds from the sale of the bonds to repay the repo loan and using the returned collateral to make delivery of those bonds to that buyer.

• If no buyer is found before the expiration of the repo, the trading desk will have to roll or renew the repo for another period with the same counterparty or unwind that repo and find a different counterparty to finance the bond.

Uses of Repos – Reverse Repos and Short Positions

• Professional investors often want to short a bond, either as an outright bet that interest rates will rise or as part of a relative value bet that the price of another security will rise relative to the price of the security being sold short.

• Say that a hedge fund wants to short the DBR 4s of January 4, 2037. It sells the bond, but then needs to borrow it from somewhere in order to make delivery. From the point of view of the hedge fund, it will do a reverse repurchase agreement.

• After initiating the reverse, the hedge fund will, at some point in time, be ready to cover its short, i.e., to neutralize its economic exposure to the bond by buying that bond back. At that time the hedge fund will buy the bond and then unwind its reverse. Specifically, the hedge fund, will buy the bond at market and then deliver it to its counterparty, who, in exchange, will return the hedge fund’s cash with interest.

• If the return on the bond has been less than the repo rate of interest, the hedge fund will have made money on an outright short position, while if the return on the bond has been greater than the repo rate of interest, the hedge fund will have lost money on an outright short.

Repo, Liquidity Management And The GFC of 2008

• A financial institution can borrow funds in many ways, some of which are more stable than others.

• The most stable source of funds is equity capital because equity holders do not have to be paid according to any particular schedule and because they cannot compel a redemption of their shares.

• Slightly less stable is long-term debt because bondholders have to be paid interest and principal as set out in bond indentures.

• At the other extreme of funding stability is short-term unsecured funding, like commercial paper. These borrowings have to be repaid in a matter of weeks or months, as they mature, when the institution, under adverse conditions, might not be able to borrow money elsewhere.

• Not surprisingly, the more stable sources of funds are usually more expensive in terms of the expected return required by the providers of funds. Through liquidity management, firms balance the costs of funding against the risks of being caught without the financing necessary to survive.
• In the spectrum of financing choices, repo markets are relatively liquid and repo borrowing rates relatively low. On the other hand, by nature of its short maturities, repo is on the less stable side of the funding spectrum, although more stable than short-term, unsecured borrowing. After all, repo collateral should prevent repo lenders from bolting too quickly in response to unfavorable rumors or news.

• Nevertheless, if repo investors do lose confidence in a financial institution, that institution’s repo financing can disappear as fast as the repos mature, which is mostly overnight. The beleaguered institution would –
  1. No longer be able to facilitate customer trades by holding inventory
  2. Not be able to facilitate customer financing
  3. Probably not remain an acceptable counterparty for derivative and even spot security transactions
  4. Have to sell inventory and proprietary positions to repay repo lenders, which sales, given their size and public nature, would likely turn into fire sales and result in significant losses
• Essentially then, while significant business losses rather than financing are the usual cause of a financial institution’s difficulties, the loss of financing is often the killing blow. The same argument, of course, applies to all leveraged investors, like part of the hedge fund world.

• In the run-up to the financial crisis of 2007-2009, borrowers financed lower-quality collateral, like lower-quality corporate bonds and lower-quality mortgage-backed securities, at the relatively low rates and haircuts available in the repo market.

• Lenders, for their part, accepted this collateral in exchange for rates somewhat higher than those available when lending on higher-quality collateral. The resulting expansion of collateral accepted for repo did not work out well during the crisis, particularly for borrowers who were unable to meet margin calls caused by declining security values, who were unable to post sufficient collateral in response to lenders’ raising haircuts, or who were unable to replace lost financing arrangements when lower-quality collateral found fewer and fewer takers. The worst- hit borrowers suffered collateral liquidations, losses, capital depletion, and business failure.

Repo Financing & Collapse of Bear Sterns

• Bear Stearns generally financed its business by borrowing funds on a secured and unsecured basis andthrough the use of equity capital. During 2006, Bear Stearns decided to reduce the amount of short-term unsecured funding,primarily commercialpaper,thatitborrowed.

• The firm made this decision primarily based on its belief, that commercial paper tended to be confidence-sensitive, and could become unavailable at a time of market stress, while secured borrowing based on high-quality. collateral is generally less credit sensitive and therefore more stable.

• Bear Stearns implemented this strategy in late 2006 and 2007, and succeeded in reducing its short-term unsecured financing from $25.8 billion at the end of fiscal 2006 to $11.6 billion at the end of fiscal 2007, and specifically reduced its commercial paper borrowing from $20.7 billion to $3.9 billion.

• Thatfundingwasreplacedbysecuredfunding,principallyrepoborrowing.

• As part of the firm’s transition away from unsecured borrowing, Bear Stearns also substantially increased the average term of its secured funding during the first half of 2007.
• Bear Stearns was able to obtain longer term repo facilities of six months or more to finance assets such as whole loans and non-agency mortgage-backed securities and generally limited its use of short-term secured funding to finance Treasury or agency securities.

• By increasing the amount of its long-term secured funding, the firm believed that it could betterwithstand a liquidity event. From approximately August 2007 to the beginning of 2008, however, thefixed income repo markets started experiencing instability, in which fixed income repo lenders beganshortening the duration of their loans and asking all borrowers to post higher quality collateral tosupportthose loans.

• Although the firm was successful in obtaining some long-term fixed–income repo facilities, by late 2007 many lenders, both traditional and non traditional, were showing a diminished willingness to enter into such facilities.

• During the week of March 10, 2008, Bear Stearns suffered from a run on the bank that resulted, in myview, from an unwarranted loss of confidence in the firm by certain of its customers, lenders, and counterparties.

Repo Financing & Collapse of Bear Sterns

• In part, this loss of confidence was prompted by market rumors, which I believe were unsubstantiated and un true, about Bear Stearns’ liquidity position. Nevertheless, the loss of confidence had three related consequences: prime brokerage clients withdrew their cash and unencumbered securities at a rapid and increasing rate repo market lenders declined to roll over or renew repo loans, even when the loans were supported by high-quality collateral such as agency securities; and counterparties to non-simultaneous settlements of foreign exchange trades refused to pay until Bear Stearns paid first

• This loss of confidence in Bear Stearns . . . resulted in a rapid flight of capital from the firm that could not be survived.

Repo Financing & Collapse of Lehman Brothers

Point of view expressed by Lehman Brothers Holdings Inc.(LBHI)

• The point of view expressed by Lehman Brothers was that its primary clearing bank JP Morgan, used its position in the moment of crisis, to make moves to leapfrog JP Morgan over other creditors by putting itself in the position of an over-collateralized creditor, not just for clearing obligations, but foranyandallpossibleobligationsofLBHIoranyofitssubsidiariesthatJPMorganbelievedcouldresultfrom an LBHI bankruptcy.
• To simplify this further, JP Morgan was asking for too much collateral, way more than what it needed and used its position as the primary clearing bank of Lehman Brothers to extort the company constantly in a way that hastened the downfall of the bank.

Point of view expressed by executives at JP Morgan

• Many executives at JP Morgan maintain till date that the vilification of the investment bank is incorrect and misleading. They believe that JP Morgan, unlike most other counterparties to Lehman at that time, did not shut Lehman Brothers of completely even when JP Morgan knew the risks associated with dealing with the banking giant at that moment.
• JP Morgan executives believe that Lehman Brothers could have provided the collateral that was requested from them and such requests were reasonable at the time.

General And Special Repo Rates

• Repo trades can be divided into those using general collateral (𝐺𝐶) and those using special collateral or specials.

• In the former, the lender of cash is willing to take any particular security, although the broad categories of acceptable securities might be specified with some precision.

• In specials trading, the lender of cash initiates the repo in order to take possession of a particular security. For these trades, therefore, it makes more sense to say that “counterparty A is lending a security to counterparty B and taking cash as collateral” as opposed to saying that “counterparty B is lending cash and taking a security as collateral,” although the two statements are economically equivalent. For this reason, when using the words “borrow” or “lend” in the repo context, it is best to specify whether cash or securities are being borrowed or lent.

• Also, as another note on market terminology, bonds most in demand to be borrowed are said to be trading special, although any request for specific collateral is a special trade. Each day there is a 𝐺𝐶 rate for each bucket of collateral and each repo term. The most commonly cited 𝐺𝐶 rates are for repos, where any U.S. Treasury collateral is acceptable, and the 𝐺𝐶 rate refers to the overnight rate for U.S. Treasury collateral.
• With respect to special rates, there can be one for each security for each term. But every special rate is typically less than the 𝐺𝐶 rate: being able to borrow cash at a relatively low rate induces holders of securities that are in great demand to lend those securities, while being forced to lend cash at a relatively low rate allocates securities that are in great demand to potential borrowers of that security.

• Differences between the 𝐺𝐶 rate and the specials rates for particular securities and terms are called special spreads. 𝐺𝐶 trades usually suit repo investors – they obtain the highest rate for the collateral they are willing to accept.

• Traders intending to short particular securities have to do specials trades and must decide whether they are willing to lend money at rates below 𝐺𝐶 rates in order to borrow those securities. Funding trades are predominantly 𝐺𝐶. Should an institution find itself wanting to borrow money against a security that is trading special, however, it will lend that security in the specials market and borrow cash at a rate below 𝐺𝐶, rather than financing that security as part of a 𝐺𝐶 trade.
• In the United States the 𝐺𝐶 rate is typically close to, but below, the federal funds rate. The latter is the unsecured rate for overnight loans between banks in the Federal Reserve system. By contrast, repo loans secured by U.S. Treasury collateral are safer and should trade at a lower rate of interest.

• The fed funds-𝐺𝐶 spread generally widens during times of financial stress. At such times the demand to hold Treasury bonds and to lend cash on Treasury collateral increases as part of flight-to-quality trades.

• In addition, willingness to lend Treasury bonds in repo declines as market participants fear that collateral may not be returned, either because a counterparty will fail to return collateral or because a counterparty’s counterparty will fail to do so. It was observed that extremely wide spreads prevailed in the months after the failure of Lehman Brothers.

• Special rates for a particular issue to a particular date are determined by the demand of borrowing that issue to that date relative to the supply available. This statement is obvious in some ways, but the important point is that the demand and supply to borrow and lend issues is not the same as the demand and supply to buy and sell issues.
• In fact, because some owners of U.S. Treasuries, for institutional reasons, do not lend bonds in repo markets, the amount of a particular issue available for borrow might be somewhat less or very much less than the amount outstanding, depending on the distribution of ownership of that issue across various types of institutions.

• Put another way, a bond that trades rich relative to neighboring bonds, implies a high demand to own that bond relative to the outstanding supply. But the bond may or may not trade very special in repo depending on the extent traders want to short it relative to the supply available for borrow.

• Given this reasoning, predicting the special spreads of individual bonds is quite difficult. Having said that, there is one predominant explanatory factor for special spreads in the United States, namely, the auction cycle: the most recently issued bonds of each maturity trade special.

Special Spreads in The US And The Auction Cycle

• The U.S. government sells bonds of different maturities according to a fixed schedule. The most recently issued bond of a given maturity is called the on-the-run (𝑂𝑇𝑅) or current issue while all other issues are called off-the-run (𝑂𝐹𝑅).

• However, the second most recently issued bond of a given maturity does have its own designation as the old issue; the third most recent as the double-old issue; etc. As a general rule, at each maturity, the 𝑂𝑇𝑅 trades the most special, followed by the old, followed by the double- old, etc.

• The special spreads equal the 𝐺𝐶 rate minus the respective bond repo rates

• The table in the previous slide illustrates how the more recently issued bonds at each maturity trade more special. The table also shows that the 𝑂𝑇𝑅 10-year trades more special than the 𝑂𝑇𝑅 30-year, a regularity that has been true for some time.
• The discussion now turns to why special rates are related to the auction cycle. Current issues tend to be the most liquid. This means that their bid-ask spreads are particularly low and that trades of large size can be conducted relatively quickly. This phenomenon is partly self- fulfilling. Since everyone expects a recent issue to be liquid, investors and traders who require liquidity flock to that issue and thus endow it with the anticipated liquidity.

• Also, the dealer community, which trades as part of its business, tends to own a lot of a new issue until it seasons and is distributed to buy-and-hold investors. As a matter of historical interest, the 𝑂𝑇𝑅 30-year bond had been such a dominant issue in terms of liquidity that traders called it “the bond.” This nickname persists to this day despite the decline of the bond’s importance relative to that of shorter maturities, in particular of the 10-year.

• The extra liquidity of newly issued Treasuries makes them ideal candidates not only for long positions but for shorts as well. Most shorts in Treasuries are for relatively brief holding periods:
  • A trading desk hedging the interest rate risk of its current position
  • A corporation or its underwriter hedging an upcoming sale of its own bonds
  • An investor betting that interest rates will rise

• All else being equal, holders of these relatively brief short positions prefer to sell particularly liquid Treasuries so that, when necessary, they can cover their short positions quickly and at relatively low transaction costs.

• Investors and traders who are long an 𝑂𝑇𝑅 bond for liquidity reasons require compensation if they are to sacrifice that liquidity by lending that bond in the repo market. At the same time, investors and traders wanting to short the 𝑂𝑇𝑅 securities are willing to pay for the liquidity of shorting these particular bonds when borrowing them in the repo market.

• As a result, 𝑂𝑇𝑅 securities tend to trade special. The auction cycle is an important determinant not only of which bonds trade special, but also of how special individual bonds trade over the course of the auction cycle.
• Further, here are some important general observations –
  1. Special spreads are quite volatile on a daily basis, reflecting supply and demand for special collateral each day.
  2. Special spreads can be quite large: spreads of hundreds of basis points are quite common.
  3. Special spreads do attain higher levels over some periods rather than others.
  4. While the cycle of 𝑂𝑇𝑅 special spreads is far from regular, these spreads tend to be small immediately after auctions and to peak before auctions. It takes some time for a short base to develop.

• Immediately after an auction of a new 𝑂𝑇𝑅 security, shorts can stay in the previous 𝑂𝑇𝑅 security or shift to the new 𝑂𝑇𝑅. This substitutability tends to depress special spreads. Also, the extra supply of the 𝑂𝑇𝑅 security immediately following a re-opening auction tends to depress special spreads.

• In fact, a more detailed examination of special spreads indicates that re-opened issues do not get as special as do new issues. In any case, as time passes after an auction, shorts tend to migrate toward the 𝑂𝑇𝑅 security, and its special spread tends to rise. Furthermore, as many market participants short the 𝑂𝑇𝑅 to hedge purchases of the to-be-issued next 𝑂𝑇𝑅, the demand to short the 𝑂𝑇𝑅 and, therefore, its special spread, can increase dramatically or spike going into the subsequent auction.

Valuing The Financing Advantage of A Bond Trading Special in Repo

• 𝑂𝑇𝑅 bonds often trade at a premium which is due to –
  • Their liquidity advantages, i.e., the ability to turn positions in these bonds back into cash with minimum effort, even in a crisis.
  • Their financing advantages, i.e., the ability to lend these bonds and borrow cash at a relatively low rate.

• It is often useful in many situations to translate special spreads into price or yield premiums. The financing value of a bond is the value, over the entire life of the bond, of lending it in repo, borrowing cash at its special rate, and investing that cash at the higher 𝐺𝐶 rate.

• The key assumption that is to be made is how special the bond will trade and for how long. Professional repo traders have an opinion about how the special spreads of particular issues will evolve over time that can be used in this analysis. Another approach is to accept the market’s view as expressed in the term structure of special spreads.

• The value of lending a certain amount 𝑎 for 𝑛 days at a spread of 𝑠 would be given by –

\(a \times \frac{n \times s}{360}\)

• As an example, consider the value of lending 100 of cash at a spread of .22% for 125 days. Here the value would be equal to –

100 × \(\frac{125 × 0.22\%}{360}\) = 0.076

This 0.076 can be interpretated as 7.6 cents per 100 market value of the bond.