What’s Behind the Fed’s Bailout of the Repo Market?
Whose Bets are Getting Bailed Out by the Fed’s Repos & T-Bill Purchases?
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
The repo market blew out in mid-September. It had already briefly blown out at the end of 2018, then settled back down. But the issues started bubbling up again. By the end of July, the repo problems made their way into the Fed’s meeting, as we learned when the minutes of that meeting were released in August.
The repo market is huge. According to the Securities Industry and Financial Markets Association SIFMA, the average daily repos and reverse repos outstanding in 2018 totaled nearly $4 trillion. Repos accounted for $2.2 trillion, reverse repos accounted for $1.7 trillion. The Fed is now playing in both, repos and reverse repos.
So the repo market – with about $2.2 trillion outstanding – blew up in mid-September and repo rates spiked to 10% before the Fed stepped into it to calm it down and keep some financial outfits from blowing up. Perhaps the Fed was fretting about contagion spreading to the rest of the financial system and potentially cause some real damage.
The Fed was certainly fretting about control over its monetary policy. The Fed has a target range for the federal funds rate, an overnight rate at which banks borrow from each other. Via this market, the Fed’s monetary policy is supposed to be transmitted to the repo market and other short-term credit markets. But when the repo market blew out, it started to push up the federal funds rate, and the Fed looked like it was losing control over its monetary policy.
So, yeah, the Fed pulled out the big guns to get this under control. But in the process of intervening, the Fed may well have bailed out some players, large or small. And we’re going to look at this today, and how certain speculators benefited from the Fed’s action.
Since the repo market blew out in mid-September, the Fed has instituted two new policies:
One, it’s once again actively intervening in the repo market mostly by buying Treasury securities and mortgage-backed securities. These mortgage-backed securities were issued and guaranteed by Fannie Mae, Freddy Mac, and Ginnie Mae. In return, the Fed is handing out cash. Its counterparties are obligated to buy back the securities when the repo matures, which is either the next day, or some date in the future, such as in 14 days. This is when the repo unwinds.
Until 2008, the Fed constantly intervened in the repo market as standard operating procedure of its monetary policy. But during the Financial Crisis, it started doing QE, and then started paying interest on the ballooning excess reserves, and repo rate manipulations were no longer needed, and it abandoned them.
The second new policy coming out of the repo blowout is the purchase of Treasury bills, with are Treasury securities with maturities of less than one year. The Fed does this to push up the amount of excess reserves at banks, in order to regain control over the federal funds rate and the repo rates.
And the amounts have started to balloon. On the Fed’s balance sheet through Wednesday, October 30, there were $215 billion in repos, up from zero two months ago. They included overnight repos that unwind the next day, and 14-day repos.
In addition, the Fed has started buying Treasury bills. And by now it is carrying $51 billion on its balance sheet.
Those two policy-moves alone added about $260 billion in assets to the Fed’s balance sheet since mid-September. This is far faster than during QE-3. It’s a huge amount in a very short time. So who might the Fed be bailing out?
Banks are lenders to the repo market. They can borrow in it too, but they can source their funds more cheaply elsewhere, such as via deposits. But other financial firms rely much more on the repo market to fund their speculative bets – and here we’re talking about hedge funds, private equity firms, Real Estate Investment Trusts, and others. For them, the repo market is the cheapest source of funding.
What they do is borrow short-term in the repo market, and invest this cash in long-term investments in a highly leveraged manner.
So I’m just going to look at one of these companies, AGNC Investment Corp, which is funding all its long-term investments in the repo market. It’s just one of many examples. I’m not picking on it, and I have no opinion on it. But it is publicly traded and has to file its financial disclosures with the SEC, and so I can get this data since it’s public, and we can see how this works and what kind of company is on tenterhooks when the repo market blows out.
I’m neither long nor short the stock, and I have no opinion on it. I have seen no data that indicates that this company had any kind of trouble in the repo market. It may have sailed through the repo turmoil without any issues. I’m just using it as an example of who is relying on the repo market and for what purposes.
AGNC is a Real Estate Investment Trust. In essence, AGNC buys mortgage-backed securities issued and guaranteed by the government-sponsored enterprises Fannie Mae and Freddy Mac, and by the government agency Ginny Mae. It also buys Collateralized Mortgage Obligations. These are long-term assets.
And it funds those purchases mostly in the repo market. It makes money off the difference between the higher yields on mortgage-backed securities and the low cost of borrowing in the repo market.
It’s essentially trying to create profits in a highly leveraged manner by borrowing short term at the lowest rates available in the US for a company like this, namely the repo market, and investing in higher-yield long-term securities. This works more or less — until the repo market blows out.
If repo rates spike to 5% or 10%, as they did, suddenly a company like this loses money. And if the repo market counterparties are unwilling to play this game, then any company in this boat would suddenly no longer be able to fund its operations and its leveraged bets, and all heck could break loose. A company borrowing in the repo market to fund long-term investments could blow up in no time.
How much money are we talking about here?
AGNC lists $106 billion in total assets on its 10-Q filing with the SEC. Of them, about $93 billion are mortgage-backed securities guaranteed by Fannie Mae, Freddy Mac, and Ginny Mae. The second largest asset are about $9 billion in receivables from reverse repos. Plus, it shows $1.2 billion in Treasury securities, and some other things in smaller amounts.
But the company has only $10 billion in equity capital. So how does the company fund these investments?
On the day of June 30, AGNC owed $86 billion to the repo market, out of $96 billion of its total liabilities. In other words, nearly all of the cash to fund its investments comes from the repo market.
During the six months period through June 30, the company cycled nearly $2 trillion with a T through the repo market, borrowing short-term, paying back the required amounts when the repos mature, and then borrowing again, constantly rolling over the increasing pile of short-term debt.
So over the first six months this year, this company has cycled through nearly $2 trillion in repos. This is up from $700 billion over the same period last year.
Maturities are typically one year or less but can be longer. Of that $86 billion in repos outstanding on the day of June 30, $66 billion were repos with maturities of 3 months or less, including $14 billion in repos that were due the next day.
So how cheap is borrowing in the repo market?
For the period ended June 30, the company paid an weighted average interest rate of 2.6% on $86 billion in borrowings.
Over the same period, the average 3-month Treasury yield was around 2.3%. So this company was borrowing at a cost of only 30 basis points above the borrowing costs of the US government.
In addition to the $86 billion in repos, the company had listed as its second largest asset $9 billion in receivables from reverse repos. This is where the company borrows actual Treasury securities to cover its short sales of Treasury securities. These reverse repos on its books have maturities of 30 days or less.
The company also uses derivative instruments to hedge against interest rate risks and other factors.
So this is just one example of the many players in the repo market. These players include hedge funds, PE firms, Real Estate Investment Trusts, banks, and others.
But banks have the lowest cost of funds, namely deposits. Many banks still only pay minuscule interest on the bulk of their deposits, such as basic savings accounts and checking accounts, including corporate checking accounts. The average cost of funds, all funding sources combined, for a bank like Wells Fargo is below 1%. And most banks don’t need to borrow in the repo market. But they’re expected to lend to the repo market.
The Fed has said nothing about which entities had trouble borrowing in the repo market. It has only discussed a couple of suggestions why banks might have refused to lend to the repo market, and has said that it is still investigating why banks had refused to lend to it. The whole thing is still shrouded in mystery, and speculation is all around it.
The big risk for a firm like AGNC is that suddenly, it’s locked out of the repo market, and can no longer borrow in the repo market, or can only do so at a very high expense when the rates blow out. But it must borrow in the repo market to constantly roll over its debts.
AGNC is just one of many players in the repo market. The daily balances outstanding of repos and reverse repos was nearly $4 trillion with a T. But only about $95 billion with a B were accounted for by AGNC’s repos and reverse repos – that’s only about 2% of the total.
All these players knew that the repo market could blow out at any time, and that it could implode their long-term leveraged bets that were funded short-term in the repo market, and that this in turn could incinerate the firm and create contagion.
But these folks weren’t born yesterday. They figured from get-go that the Fed would step in and fix the repo market if it blows out. That had been their bet. And they were right. The Fed stepped in and fixed it so that the speculative, highly leveraged games can continue, the games of borrowing short-term in the repo market and betting those funds long-term on leveraged financial speculations.
The thing is, the real economy would do just fine if hedge funds and others such as AGNC could not borrow in the repo market, but had to fund their bets in other ways. This is a corner of the financialized world that has nothing to do with the real economy, real investment, production, consumption, or jobs. It’s just some players trying to milk the financial system by taking huge leveraged risks and betting – and that’s the real bet here – that the Fed will step in and save their asses when the whole thing blows up. And that’s what the Fed is currently doing.
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