If you pay attention to financial news, starting on September 15, 2019, you’ve started hearing a lot about the Repo Market. I’m going to explain how repo works, why it ran into issues, what the mainstream news says is the underlying problem, and how Jeff Snider thinks they’re wrong.

So How Does the Repo Market Work

The Repo (re-purchase) Market was set up so that banks and other financial institutions (FI) could loan money to each other overnight to make sure everyone has enough cash to meet their daily needs and reserve requirements (amount of cash they have to have on hand in case of a crisis).

In exchange for loaning the money overnight, those banks with extra cash lying around can earn a little interest on their excess funds.

Everyone wins.

If you’re a firm that needs a little cash overnight (this sometimes happens and isn’t a big deal), you can put up some collateral (a US Treasury or another security) in exchange for the cash and a promise to repurchase the collateral the next day, plus pay a little interest on the cash you borrowed.

Another bank, financial institution (FI), or money market fund loans you cash overnight and makes a little interest from loaning you the money.

No big deal.

Well, on September 15, 2019, it became a big deal.

What happened on Sept. 15th?

For almost all of 2019, the interest financial institutions could earn lending cash in the repo market hovered right around 2%.

On Sept. 15th, it spiked up to ~6%.

Then on Sept. 16th, it spiked up to ~10%.

When the repo rate rises like that it means:

FIs and money markets aren’t willing to lend their cash overnight in exchange for collateral. The risk of an overnight loan of cash isn’t worth it to them. Even at 6% interest (which is crazy-high for today’s standards), it wasn’t worth the risk.

When the repo rate got to ~10% the Federal Reserve printed up a bunch of freshly made US dollars and loaned the cash out to the financial institutions in need (FYI the Fed doesn’t actually print out hard copies of dollars and walk down Wall Street to hand them to the bank, this is all done via computers).

So the Fed stepped in and saved the day, brought the repo rate down to 0%, and all was fine in the world.

The mainstream news was all over this.

The mainstream explanation made sense, but it was a surface-level explanation for a much deeper problem, which showed up in 2008 and is why the Fed has been unable to stop their “temporary” repo operations through the first quarter of 2020.

Three main explanations were emanating from the media:

Tax Payments Due - The FI’s had tax payments due and so since they paid the IRS in cash, they were short on cash. Liquidity Coverage Ratio - After The Great Recession in 2008, FI’s were required to hold more cash in reserves in case shit hits the fan. This leads to less cash you’re able to lend into the repo market. More Bonds / Less Cash - Since the US is the largest debtor nation in the world, the government has printed a lot of US Treasuries. Many banks are forced to buy these Treasuries in exchange for cash, which means there is less total cash in the system.

Moral of the story? Not enough cash in the system.

Jeff Snider, however, doesn’t buy it.

He says there is plenty of liquidity (cash) in the system, but there just isn’t enough good collateral. Before the 2008 crisis, one of the main sources of collateral that was traded in Repo was mortgage-backed securities.

In fact, mortgage-backed securities were treated as some of the best collateral (right behind US Treasuries) in the repo market. When the mortgages started defaulting in 2008, the repo market started rejecting any mortgage-backed collateral. Ya know, because it was dogshit.

People wouldn’t lend their cash to FI’s overnight because they knew the collateral was trash and they didn’t want to be stuck holding the poo when the system blew up. Or, if they would accept it, they would need higher interest on the cash they were loaning out. Gotta make it worth their while!

Which means the size of the “Pool of Good Collateral” was reduced by a lot:

So, now, even though the US is running a massive deficit and there are more US Treasuries in the system than in 2008, they still haven’t created enough to fill the collateral void.

So, back to Sept. 2019, banks aren’t willing to trade their cash overnight for shitty collateral. It’s not a lack-of-cash thing, it’s a lack-of-good-collateral thing.

How does Jeff Snider know this?

He says that if primary dealer banks (the ones required to buy the US Treasuries from the gov’t) needed cash because the gov’t had overloaded them with Treasuries, they could simply go sell those Treasuries into the bond market for cash.

They could then lend that cash into the repo market and end up making a double profit off the US Treasury that they were holding.

Snider also doesn’t buy that the cause of the issue is the taxes due. He says that probably had an impact on the timing, but it misses the crux of what is happening.

Plus, it’s not like taxes being due is a surprise every year. The banks know it’s coming. If it were the taxes, how come this isn’t an issue every year at tax season?

Snider says the Liquidity Coverage Ratio also plays a role, but again he’s unwilling to say that the crux of the Repo issues lie in regulations created in 2013. Again, why has Repo been fairly silent over the past 6 years (minus a 2018 freak-out)?

Snider says the banks are scared of holding stinky collateral. Okay, he’s way too much of a professional to call collateral “stinky”, but my icon is a turd and my standards are low.

You can see from that last chart, that the last major spikes in repo came during the dot-com bubble and the 2008 financial crisis. Both times, in the midst of crisis, the Fed stepped in, printed cash, and took the shitty collateral on their balance sheet.

The banks saw what happened to Bear Stearns & Lehman in 2008, and so, even though they have the cash to lend into the repo market, if the market plunges and that stinky collateral becomes completely worthless (like it did in 2008) the banks don’t want to be stuck holding the bag (as they say).

Snider says banks are also worried about some of the tricky moves being pulled in the repo market with something called “securities transformation”.

In 2008, everyone realized many mortgage-backed securities were dogshit and wouldn’t accept them as collateral. Since then banks have been trying to make up for this shortage of good collateral.

And they’ve started doing some strange things…

Financial institutions have started taking dogshit junk bonds (stinky collateral) and doing temporary swaps with US Treasuries from the primary dealer banks. The FI’s then use the US Treasuries to get cash from the Repo Market. It goes something like this:

Not only is securities transformation a thing, but there’s a process called “rehypothecation” that is common among the banks. Rehypothecation is pledging the same collateral for multiple loans.

Rehypothecation is basically a single asset being used as collateral more than once, at the same time. Banks can do this legally, with client assets. Typically this is done by clients opening a margin account and using their own assets as collateral. Bank #1, where the client opened the margin account, then takes out a loan from Bank #2 using the client’s assets as collateral.

Bank #2 then can use this collateral to take out a loan, and so on.

This creates what’s known as a “daisy chain” where one bank’s liabilities become another bank’s assets. If something goes wrong at any financial institution in the chain, there is a collateral collapse and according to 2012 court rulings, one of the banks will have first dibs on the client’s collateral.

As current law stands, banks can rehypothecate 140% of the loan amount to a client.

Banks also do this with their own US Treasuries. So they’ll buy a US Treasury, and then loan it out to someone else (who may be doing a security transformation in repo). But the issue is they are allowed to loan it out to numerous institutions. So you have all this debt created and backed by the same underlying US Treasury. I’m no trader, but rehypothecation seems risky. Especially considering the amount of debt swirling around our system.

Luckily the banks probably see that too, right?

Well, Jeff Snider did some digging and looked into Morgan Stanley’s 2018 end of year 10-K SEC filing. He found some surprising numbers (on page 121). Morgan Stanley lays out their rehypothecation situation. The bank reported $639.6 billion in “collateral received with the right to repledge”.

Guess how much they rehypothecated…

Morgan Stanley sold or pledged $488 billion of those funds.

That’s nearly half a trillion in rehypothecation. That’s a lot. And that’s just one bank.

So, let’s go back to the repo market.

When the Repo Interest Rate jumped up to 8% in mid-September, banks sat on their thumbs and refused to put cash into the system. Not due to lack of cash, but because they knew that the market was rotten with stinky collateral that has been “manufactured” to try to fill the collateral-void.

So the Fed jumped in and said,

So how do we know that the Fed is taking all the stinky collateral?

Well, I went onto the Federal Reserve Bank of NY’s website (credit to George Gammon for the idea) and looked through each of their Repo Operations from July 1, 2019 to Feb 4, 2020.

Here’s a graph showing the percent of mortgage-backed securities submitted to get overnight cash for 1-day repo operations:

You can see there’s a trend moving upwards. More and more FIs are pledging their stinky collateral in the repo market now that the Fed will take it.

But wait? You’re showing me percentages…are repo operations increasing? You bet.

And this isn’t even including any of the 14-day repo operations. Yes, I do know that because I went page-by-page through the NY Fed’s website and copy/pasted all these values into an Excel sheet so I could make a chart and see what was going on.

So the Fed is printing money and handing out cash in exchange for stinky collateral so the entire system doesn’t grind to a halt. Solid plan.

Before we get to what really happened in 2008, we need to discuss Eurodollars. More to come in Part 2: Why Eurodollars Are a Big Deal