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The Repo Market Is More Than Mere Plumbing

Stephen Mihm

(Bloomberg Opinion) -- The repo market is often described as the “plumbing” of the financial system, especially when it starts to look clogged and in need of the kind of flushing that only the Federal Reserve can provide. It’s an effective metaphor, just not an accurate one.The history of repo shows that it’s far from the stable system of financial pipes and more like a series of end-runs designed to circumvent government regulations and restrictions. Its latest woes may well be another installment in a decades-long story of regulatory arbitrage.

The standard definition of a repo, or repurchase agreement, is a sale of securities from a borrower to a creditor, with an agreement to repurchase them at a set date in the future for a specified price. It’s akin to a loan, in that the repurchase price covers the original amount and a little more – a kind of “interest” payment.

If the borrower fails to buy back the security, then the creditor can sell the security to satisfy the outstanding debt. A repo, then, is a bit like pawning a Treasury bond for cash. It’s the same principle – up to a point. Unlike pawned jewelry, the bonds held by the creditor aren’t held on a shelf until the repurchase date comes due; they can be sold or used to settle other repo agreements.

Repurchase agreements remained exceedingly rare until World War I, when Congress passed a tax on financial instruments to defray the costs of the conflict. The levy hit banks hard: Every time a bank borrowed money from the Fed, it had to pay a tax.

What to do? The Fed, eager to ensure the health of the banking sector, concluded that it could “loan” money to member banks using repos. It would buy bonds from banks, and the banks would buy them back, paying a little fee for the privilege. And while the Fed couldn’t lend money to non-member banks, it set up repos with these banks, too.

At first glance it looks like a plumbing job connecting the Fed to banks for the sake of smoother operations. But it was, in point of fact, an end run around Congress and its ill-considered tax. The whole thing was pretty clever, if a bit underhanded -- prop up the demand for bonds when the government began borrowing at a staggering clip. Once the war was over, this particular set of plumbing was left to rust.

As the Great Depression reached its depth, the financial system was struggling with new rules and regulations issued during the New Deal. It would be only a matter of time until repo’s triumphant return.

Many reformers argued that banks during the 1920s had been reckless in their competition for deposit funds, offering interest rates that they could not realistically pay. In 1933, the Fed stepped in, issuing Regulation Q – a prohibition against banks paying interest on demand deposits.

Problem solved? Well, not really. As the U.S. pulled out of deflation in the 1950s, interest rates began rising. This left many corporations and municipalities – all of which had to maintain significant amounts of cash to handle payrolls and other expenses – in a difficult position. If they deposited their cash, they earned nothing, thanks to Regulation Q.

Then someone realized – it’s not clear who – that repos supplied a solution. As early as 1956, the New York Times detailed the new practice, noting that larger corporations had effectively become pawn shops, buying up bonds from dealers for a day or more, then selling them back.

“The parties to these transactions,” the Times dryly noted, “seem to be taking unusual steps to heed the injunction of Polonius to be neither a borrower nor a lender.” But the real reason for this innovation, the paper made clear, was to circumvent the interest-rate ceiling on deposits.

The Times noted other advantages as well. Repo agreements were “made with a minimum of red tape.” They enabled the corporations who lent the money to make more than they could have if they actually collected interest on governments bonds. At the same time, the dealers who pawned their bonds for cash got a better deal than if they borrowed money from banks. In circumventing Regulation Q, everyone was a winner.

In the following twenty years, repos took off, particularly once inflation began spiraling out of control. After 1969, outstanding repos totaled a mere $4.9 billion. A decade later, they had ballooned nearly tenfold, to $45 billion. Each time interest rates went up, repos became more and more popular.

Fed economist Kenneth Garbade, who has written on the history of repos, attributes some of the shift to other factors: significant growth in the quantity of U.S. Treasury debt, as well as growing volatility in medium- and long-term interest rates. The computerization of corporate finances, enabling an exact, up-to-the-minute accounting of cash flows, also spurred their growth.

By 1979, the Wall Street Journal sang the praises of repos, joining a growing chorus of proponents. It quoted an executive at a heavy equipment manufacturer who noted: “At these interest rates, I’d be crazy to leave my money in a [non-interest] checking account.”

Those same checking accounts, the Journal noted, had an additional drawback: They were subject to reserve requirements prescribed by Regulation Q. “Money gleaned through repurchase agreements,” the paper reported, “doesn’t need to be held in the nonearning reserves, provided that that collateral used is government or federal agency securities.”

Eventually, plenty of other non-financial institutions joined the party: school districts eager to make a quick buck off their surplus cash, for example. At the same time, the market grew more complex, with broker dealers pioneering the special collateral reverse repo. This enabled dealers to hedge, borrowing securities that could be delivered against short sales.

These feats of regulatory arbitrage began to end badly in the early 1980s. Several bankruptcies of broker dealers involved in repos made it clear that the financial system was in uncharted territory. The repo market was exposing its participants, particularly creditors, to unforeseen risks.

Worse, the legal system had fallen well behind the market. What should happen to repos in the event of a bankruptcy petition? Should they be subject to the “automatic stay” that suspended all pre-petition claims? If so, this might easily trigger a liquidity crisis, as repos went into lockdown pending settlement of the bankrupt firm. This almost happened when Drysdale Government Securities failed in 1982.

A decade after the financial crisis, it appears that the repo market is at it again. Many smart observers are blaming the recent turmoil on Dodd-Frank and the Basel III capital accords. They force banks to set aside huge amounts of cash as reserves and deprive the repo market of liquidity, the argument goes. This allows the banks to claim that they would love to lend in the repo market, but – sorry! – their hands are tied.

Perhaps. But the history of this shape-shifting market suggests the opposite conclusion – that the repo market has been used to evade those very same regulations, and that we’re now seeing the first tremors of the experiment.

Time will tell, but keep one thing in mind: The repo market isn’t a boring piece of plumbing. It’s a ever-evolving system of cutting-edge financial innovation and regulatory evasion. Ignore it at your peril.

To contact the author of this story: Stephen Mihm at smihm1@bloomberg.net

To contact the editor responsible for this story: Mike Nizza at mnizza3@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to Bloomberg Opinion.

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