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While relatively unknown, the repo market (or repurchase agreement market) constitutes a major part of the financial system. A $2.2 trillion part, to be exact.
Experts say about $2 trillion to $4 trillion in the repo–collateralized short-term loans – are traded each day.
In this article, the Zero Theft Movement will provide a thorough explanation of the repo market and the prominent role it played in the 2008 financial crisis that caused countless Americans lasting monetary and emotional damages.
The Zero Theft Movement is dedicated to eradicating the rigged layer of the economy. We achieve this with your help in researching, debating, and voting on which specific areas of the U.S. financial system are rigged, how much is being ripped off from the public, and by whom.
For more on recent difficulties with repurchase agreement market
What is the Repo Market?
Repurchase agreements (or repo) is a short-term collateralized loan.
In short, repo refers to a form of short-term borrowing for dealers in government bonds or other debt obligations. Repo involves a dealer selling government securities to investors typically but not necessarily for a night. Dealers promise to purchase the security back in the future at a slightly higher price. The difference between the original price and the higher price is called the ‘repo rate.’
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This transaction is often made because buyers often have large cash pools sitting around not accruing interest and dealers can borrow cheaply to fund short-term projects/needs. Furthermore, there’s typically minimal risk involved for both parties. in order to quickly generate short-term capital.
From the buyer’s side, the deal is called a repo; from the seller’s side, the deal is called a reverse repurchase agreement.
Main Types of Repo
Repos can be placed in two main categories: third-party repo and bilateral repo.
Third-party repo (a.k.a. tri-party repo)
Constituting 80%-90% of the repo market, third-party repo (or tri-party repo) is the most common form of the repurchase agreement. The securities dealer Salomon Brothers, along with the clearing bank Manufacturers Hanovers, pioneered tri-party repo in the late 1970s.
Tri-party repo works as follows: A clearing agent or bank acts as the custodian in the transactions between the buyer and sellers, protecting both parties’ interests. The third-party holds the securities, making sure the seller gets their money and the buyer delivers the securities at the maturation date.
Clearing agents, apart from their custodial duties, also value the securities and make sure the appropriate margin gets applied. They settle and authorize the transaction on their books, as well as help dealers, optimize collateral.
Well-known clearing agents include (but are not limited to) JPMorgan Chase and Bank of New York Mellon.
The bilateral repo market has buyers and sellers directly exchanging money and securities. No clearing banks were involved. Bilateral repurchase agreements have the flexibility to permit general collateral and specific collateral that have eligibility requirements set by the buyer.
It follows, then, that the parties involved in bilateral repo transactions have to take on much more responsibility than they would with a tri-party deal. Furthermore, the parties do not receive the extensive protections provided by clearing agents.
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Repo Market Risk
As mentioned in the introduction, the repo market constitutes $2.2 trillion of the financial system. It serves as a cornerstone of the U.S. financial system, allowing banks, companies, and investors to have the requisite liquidity to finance their daily operations.
That means a repo market crash would result in considerable damages globally.
When investors are afraid of lending or when the cash reserves run low, it can send the repo rate skyrocketing multiple times above the federal funds’ benchmark rate (2%-2.25%). As you might expect, this has a ripple effect.
Trading in stocks and bonds can become difficult. High repo rates can also limit lending to businesses and consumers. If the disruption persists, it can stall the U.S. economy, as it heavily relies on the free flow of credit.
Repo 105, the Lehman Brothers, and the 2008 Financial Crisis
Repo markets majorly contributed to both the housing market boom between 2004-2007 and the following financial crisis in 2008. In the four years of the housing boom, the asset-to-equity ratio of U.S. broker-dealers ballooned from 24:1 to 35:1. This balance sheet expansion was largely due to repo borrowing.
On September 15, 2008, the financial crisis reached its climax. Lehman Brothers, the fourth-largest U.S. investment banking firm at the time, filed for the largest bankruptcy in history. The company had relied heavily on the tri-party repo market to fund its securities inventory. Turns out, their securities inventory dangerously consisted of illiquid mortgage-backed securities (MBSs).
The firm allegedly had $639 billion in assets and $619 billion in debt. According to the bankruptcy court’s 2,200 page postmortem, Lehman’s value plummeted by 93%. The failure of the firm pushed the global financial system to the brink of collapse.
What is Repo 105?
In the leadup to the crisis, Lehman had found itself in a dilemma due to its involvement in the tri-party repo market and MBSs.
Firm management believed raising equity capital would send a bad signal to financial markets. But on the other hand, they found reducing leverage through asset sales was just as problematic. The firm could not sell assets without recording losses, which would reveal its unstable status and tank the collateral value of its remaining holdings.
That’s when the now-infamous Repo 105 came into the picture.
Dr. Agatha Jeffers, a business professor at Montclair State University, published a study examining the link between Repo 105 and Lehman Brothers. Jeffers writes, “To maintain its stellar reputation, Lehman engaged in this common arrangement but instead of utilizing the normal practices, Lehman employed creative but deceitful accounting practices known as Repo 105. Essentially, Repo 105 is an aggressive and deceitful accounting off-balance-sheet device that was used to temporarily remove securities and troubled liabilities from Lehman’s balance sheet while reporting its quarterly financial results to the public. These transactions were recorded as sales rather than as loans.”
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Repo 105 in action
Dr. Jeffers continues on to explain in steps how Lehman Brothers allegedly used Repo 105.
Step 1: Lehman Brothers purchases a government bond from another financial institution under the Lehman Brothers Special Financing unit in the U.S.
Step 2: Just before the financial quarter comes to a close, the U.S. unit transfers the bonds to its London affiliate, Lehman Brothers International.
Step 3: The London affiliate acts as a seller on the repo market. It gives the assets to a counterparty in exchange for cash and agrees to buy back the securities at the beginning of the next quarter at a higher price. The assets given were at least 105 percent of the cash received.
Step 4: Lehman used the cash received to pay off a large amount of Lehman’s liabilities.
Step 5: The temporary reduction of assets and liabilities allowed Lehman to report to regulators, investors, and the public healthier quarterly financial statements and the corresponding leverage and other risk ratios.
Step 6: At the beginning of the next quarter, Lehman was able to obtain loans from financial institutions due to their healthy financial statements.
Step 7: A few days later, Lehman Brothers Holding repurchases the assets from their London Affiliate at 105 percent. Lehman’s assets, liabilities, and leverage again grows considerably. As a result, its balance sheet returns to its true inferior position. These transactions usually took place in a period of seven to ten days around the end of the quarter.
In short, Lehman Brothers allegedly ‘cooked their books.’ It created the illusion that they were performing well, as it continued to dig itself deeper and deeper into a hole. This eventually led to its historic bankruptcy and the extreme strain on global financial markets.
The Lehman affair and the financial crisis as a whole exposed the loopholes in the repo market. After the debacle, the Fed has worked to analyze and reduce risk. It has pinpointed at least three major areas of concern:
- The tri-party repo market’s dependence on the intraday credit provided by clearing agents;
- The absence of an effective strategy to help liquidate the collateral in case the dealer defaults;
- The lack of viable risk management practices.
In late 2008, the Fed and other regulators began establishing regulations to address these concerns. Regulators’ bodies incentivized banks to not loan out their safest assets. This has generally had a positive effect, reducing these loans from $4 trillion to about $2 trillion.
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