The Repo Bailout: A New Crisis or an old Liquidity Crunch?
The trillions in quiet cash and securities that are transferred back and forth between banks each day and night, comprise the repo market which is short for re-purchase agreement. The loans and collateralized transactions that often occur in the wee hours rarely garner much attention, but they are, in many respects, the hidden flywheels of the financial system.
Repo’s involve the short-term selling of U.S. Treasuries, and they are also a critical source of cash for non-bank entities like money market funds and brokerage firms. And if their rates go off the rails economic trouble could follow.
In Bloomberg’s recent feature entitled, “The Repo Market’s a Mess,” they refer to the short term borrowing exchange as, “the world’s biggest pawn shop: It helps a wide range of other transactions go more smoothly including trading in the over $16 trillion U.S. Treasury market.” The rates charged for repos typically align with the Federal Funds rate, but back in September
something went wildly wrong as volume surged and short-term rates soared as high as 10%forcing the Fed to pump over $128 billion into the financial system to stave off a liquidity collapse. It was the first time the Fed has intervened in financial markets in ten years.
“The repo market is important,” according to Bloomberg, “because it serves as thegrease that keeps the global capital markets spinning.” So last month’s dramatic bailout, should not be overlooked.
Repo transactions ensure that banks have the cash and liquidity needed to fund their various lending activities, and the system works well when the repo rate hugs the Fed’s benchmark. When there’s not enough cash in the system or sufficient reserves to meet demand, however, that rate can surge creating chaos in short-term lending that impacts U.S. banks, corporations, money market funds, and an array of institutional investors.
Last month’s crushing demand for cash is being blamed on everything from treasury debt and corporate tax payments — to crisisera monetary policy and post-recession banking regulations. Regardless of the cause, when supply and demand metrics push repo market rates to historic levels, it poses a threat to the financial system — one that we have not seen in over a decade.
A just released study by the National Bureau of Economic Research concluded that, “the financial panic of 2007-8 stemmed from a run on the repurchase or repo market — the primary source of funds for the securitized banking system.” The research further suggests that the sudden loss of liquidity and resulting repo rupture, directly led to the broader financial crisis:
“Based on their analysis, the authors hypothesize that when the subprime real estate market weakened early in 2007, repo market buyers grew anxious about the quality of the securitized assets in the bonds and the increasing haircuts on deals. Although some
banks raised capital by issuing new securities in response, those efforts soon fell short because of slumping real estate, and mortgage, prices … By August 2007, market fears reached a critical mass that led to the first run on repo. Lenders were no longer willing to provide short-term financing at historical spreads, and repo haircuts jumped to new highs, tantamount to massive withdrawals from the banking system.”
The recent repo rate uproar puts the Federal Reserve smack in the midst of another liquiditycrisis forcing the government to treasury’s again, intervene in the nation’s markets again, and inject cash into the financial system again. Haven’t we been here before? And didn’t itprecede a credit crunch, a banking crisis, and a catastrophic financial downturn?
The Federal Reserve Bank of San Francisco concluded that:
“The 2007–08 financial crisis was the biggest shock to the banking system since the 1930s, raising fundamental questions about liquidity risk. The global financial system experienced urgent demands for cash from various sources, including counterparties,
short-term creditors, and, especially, existing borrowers. Credit fell, with banks hit hardest by liquidity pressures cutting back most sharply.”
Alas, dramatic rate cuts and massive liquidity infusions did little to stop the global financial crisis of 2008. It, of course, went on to become the worst economic disaster since the Great Depression. And while the Fed’s recent intervention in the short-term lending market helped stabilize current rate volatility, a host of questions and concerns have emerged — Has the Fed
finally lost control of rates? Can monetary policy still steer the economy? Are the financial markets more vulnerable than we realize? And, without a lasting repo fix, is another downturn imminent?
It wasn’t too long ago that the U.S. financial system teetered was on the brink of dissolution asreal estate values plummeted, foreclosures soared, and banks large and small folded on what seemed like a moment’s notice. And amid the federal bailouts, conservator ships, and credit freezes — investors, traders, savers, and businesses sought shelter from volatility and risk.
They found it in gold which almost doubled in value during the most punishing years of the financial crisis from 2007 to 2012.
So, if the current repo chaos is a symptom of a financial system under pressure and an omen of broader economic danger to come gold will once again be the go-to crisis hedge for wealth protection and long-term peace of mind.
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