Quiz 3 Flashcards
Repo
Agreement to sell securities one day and repurchase them at a later date for an agreed upon price
- equivalent for a cash transaction (cash means “transaction today,” not typical cash) plus a forward
- economically, collateralized borrowing of funds
- terms of contract are fixed at time of trade (which is why we quote it as a rate)
A. Overnight (O/N) repo has a 1 day maturity
B. Term is any horizon greater than O/N
C. Rolling over a trade: renewing/replacing at maturity
Repo vs reverse repo
Repo = RP = Repurchase agreement (named from dealer perspective). Dealer borrows cash, lends collateral.
Reverse repo = RRP = dealer lends cash, collateralized.
RP = repo out securities
RRP = reverse in securities
From dealer perspective
Motivation for repos from perspective of cash borrower
From the perspective of the cash borrower: repo is a means of short term funding by using your assets as collateral
- puts all your assets to work
- finance security purchases
- collateralized funding may be your only option
- cheaper way to borrow than unsecured if have assets, may as well use this
Motivation for repos from perspective of cash lender
From the perspective of the cash lender: way to invest (earn returns on) excess cash balances and maintain funding liquidity
- e.g. MMMFs invest cash with O/N repos to satisfy their regulatory requirement of being able to liquidate >= 10% of assets within 1 day
- lend against a particular security as collateral (to deliver into a short sale)
MMMfs = money market mutual funds
Externality: repo market enhances the liquidity of securities used as collateral
If I’m holding 2 securities and one is high demand and other isn’t, the high demand is higher price and has a more expensive rate
Repo securities out - day t
Securities dealers are active repo cash borrowers. (Ways to finance security purchases/holdings)
Institutional investors are primary source of repo cash lending (MMMFs, banks, insurers, and others w large cash positions. Or “repo in” a specific security for a trading strategy (e.g. hedge fund))
Cash borrower (seller of collateral) has securities going to the cash lender (buyer of collateral). Cash goes from cash lender to cash borrower Collateral legally belongs to the lender of funds until maturity This all occurs at day T
Repo unwind
At day t+1 (day it matures, O/N repo would mature at t+1), securities go back from the cash lender to the cash borrower. Cash + interest from the borrower to the lender
Note that collateral is exempt from automatic stay in bankruptcy (creates “fire-sale” risk) - if sell a lot at once. Bankruptcy creates fire sale risk. Exemption from automatic stay increases fire sale risk bc holder of collateral can liquidate it immediately. If one person sells a large quantity of particular asset, price would fall and could trigger other participants to demand more of the security as collateral to maintain same level of funding which could prompt more collateral liquidations and so on.
Also repo rates are quoted as rate of interest on cash borrowed (in exchange for securities)
Repo borrowing on the balance sheet
Securities typically remain on the collateral seller’s balance sheet as assets. Cash borrowed appears a secured loan
Borrower of cash (dealer) increases assets and liabilities (leverage)
Borrower: has assets: $5 in securities (securities sold in repo are unchanged). Add Cash (borrowed) for $5. Cash is borrowed against the securities on the B/S. Securities remain on the B/S
Liabilities: have $4 in debt and $1 in equity. Add repo (cash owed) for 5. More levered after wedding the repo
Accounting treatment focused on “economic substance” not legal status, so dealer keeps the securities on his balance sheet. This means that a accounting is intended to capture the economic risk of the transaction, rather than the legal status of the collateral who officially holds the collateral at a given point in time.
Lender of cash (asset manager) converts assets
Assets: dealer repo (secured loan): +5; cash (lent): -5
No liabilities changing
This simply changes their assets from cash to dealer repo (secured loan)
Collateral type as percent of total
Virtually any security can be used as collateral in a repo transaction
Most common are treasury securities (66%) bc risk free, don’t worry about rate going down.
Then Agency MBS (18%) which are mortgage backed securities - debt securities backed by mortgage loans that are guaranteed by the US government sponsored agencies (GSEs). Agency MBS formed from converging mortgage loans
Then TIPS (6%)m corporate (3%)m equities (3%)m other (2%)m agency (1%), and abs (1%)
Function of repo = safe funding from lender’s perspective. Borrower needs deep market with lots of participants
What does the repo rate reflect
- Repo term - longer term has higher rate
- Collateral quality/desirability: general collateral (GC - within some particular security type, will accept any in face value/mortgage I want) vs special (borrow against equity has higher price than against treasury bc of risk)
- Collateral usability: rehypothecation rights (if I take security and sell to someone else, I need to bring it back.) Re-using collateral for something else - collateral being used again, similar to broad MS going up from lending. Same effect on credit. Willing to pay more/cover rate on loan - give a lower rate on the loan if get this
- Counterparty risk: centrally cleared trades are “novated” - not sensitive to counterparty risk of centrally cleared transaction. Novated refers to a centrally clearing mechanism
- Collateral management: triparty vs bilateral. Triparty is less expensive bc cash borrower - collateral management - prefer not do this and outsource. Triparty will lower costs. Third party manage. Don’t confuse w central clearing
Bilateral: principal to principal transaction, handle trade bilaterally
Margin
Margin is an additional cost to the borrower of funds
Margin = (market value of collateral/funds borrowed) -1
1. Initial margin: borrower is being forced to over-collateralize the face value of the loan by x%
Ex: 10% margin —> $11M collateral required to borrow $10M
Interest calculated on value of cash borrowed
- Variation margin: based on changes in mark to market collateral value over life of loan. Margining has increased post crisis, especially for more riskier/less liquid collateral
Tri party repo
Example where Blackrock is the lender, Jeffries is the borrower, and bank of New York Mellon is the custodian
Blackrock money fund is the $ lender. From their dollar account and their securities account, they lend to Jeffries’ $ account and securities account. They do this thru the bank of New York Mellon custodian
The money from the securities account goes into segregated securities
Essentially, the BNY helps allow the trade to happen
More on tri party repo
GC collateral only
Rehypothication within triparty platform only
Provides collateral management and reporting
-mark collateral to market daily
-calculate, collect/transfer margin daily
-automated collateral selection and substitution
-simultaneous transfers
-trade confirmation
-maintain legal agreements, and collateral criteria
Trade is not novated. Not central clearing. Settle transaction on book of foehn party
In 1984, it was questionable if collateral was exempt from automatic stay. Congress makes it excerpt. Triparty and ‘84 law allowing liquidate helps this market.
Adverse feedback
Interaction between changes in collateral/funding value of securities and cash/market prices of securities
Accelerates funding constraints of institutions reliant on collateralized funding against questionably valued securities
Lender gives the borrower the cash raised. Borrower gives lender the securities needed
Stock of securities influencing the borrower, can increase or decrease in size and influence this transaction
For institutions that are reliant on short term funding (borrower), when collateral value falls, their ability to borrow decreases. Thus, the securities that they need to borrow the same amount of cash will all’s increase. This trend continues as the adverse feedback loop (the funding constraint accelerates)
Feedback loop is an effect’s reverberation back to itself, which magnifies the ultimate outcome
- example from class - fun on security. When it’s issued, market participants know that it will be heavily traded, so those so need to transact quickly or often will transact in this security. Since traders that transact frequently are selecting into the liquid security, it becomes even more heavily traded,which increases its liquidity, making it that much more desired by this type of trader
- adverse feedback is when the effect is negative. The slide shows a participant borrowing funds with some set of securities. As value of securities go down, participant needs to post more collateral to raise same quantity of funds. Less funding value of securities, less they are valued in cash market (outright purchases/sales). The participants’ inability to raise funds w these securities affects the cash value of the securities held as assets by this participant which in turn makes the participant even less able to fund itself with these securities and so on.
The role of leverage
Losses on mortgage backed securities were a few hundred billion. Not a huge sum. Global stock market capitalization was $60T pre crisis (1% drop = $600B loss)
The valuation changes more than amount falls bc don’t have underlying information on risks. Hard to get exact price
Leverage, interconectedness, and opaqueness amplify an adverse effect
Look at Bear in early 2008. They have $396B in assets, $385B in debt, and $11B in equity. Leverage is 36:1
Now imagine 2 outcomes. If go up by 3%, then assets are $408B, debt is $385B, and equity $23B. Ratio is now 18:1
If go down by 3%, assets are $384B and debt is 385B and equity -1B
See that just a 3% drop is a big problem, but a 3% rise changes it so much. They are extremely levered, which is a problem.
Commercial banks leverage
Looking at total asset growth (percent quarterly) on the Y axis and leverage growth (percent quarterly) on the X axis
—> Quarterly change in asset values against quarterly change in leverage.
We would expect to see that as asset values go up, leverage ratio goes down, as seen in previous slide.
But, this graph shows instead a target average leverage ratio. Not changing the leverage ratio that much. No clear relationship in 1963-06, looks like keeping leverage relatively constant
Even more so from 2010-19. Very very little leverage growth. Basically at 0 change no matter the total asset growth for commercial banks
Dealers leverage
Same thing, looking at quarterly change in asset values against quarterly change in leverage
Non-bank financials - pattern shows when assets value goes up, increase leverage. Dealers aggressively increase leverage in good times, cut leverage aggressively in bad times to avoid insolvency. So strong positive relation that when asset values go up, leverage up.
Less so today, not as pro cyclical. Slight changes in leverage but more constant lev
Leverage ratios for bear, Morgan Stanley, Merrill, Lehman from August 06 to feb 08
See that they are all increasing leverage during this period
Bear stearns has the most leverage, but not that much more than the rest and their increase during the period was smaller than the others.
Market liquidity vs funding liquidity
Relative price anomalies may arise for many reasons
One possible common reason: market liquidity
Funding and market liquidity are two related but distinct concepts
Funding liquidity: characterizes a firm’s access to funding. Ability to turn stuff into cash/get cash
Market liquidity: characterizes a security or market. Ease to transact in the market.
Measures of market liquidity include trading volume, transactions costs, and price impact of a trade (did it move the market?)
Ultimately may run out of money as can’t do trade
Financial intermediaries are often referred to as “liquidity providers”
- willing to take the other side of the trade for hedgers and speculators/arbitrageurs (for a price)
- aim to offset exposure acquired from providing this service
