this video is sponsored by Morning Brew. Click the link in the description below to start getting your summary of the daily news. Today, most of us have probably heard the term repo at one point or another. Perhaps you remember the repo crisis that occurred in 2019, where financial institutions ran into trouble because of a squeeze on cash. Or perhaps your mind fills with images of a buff guy with a horseshoe mustache yelling at people in California about their overdue car payments. Is this your car? Yeah, this is my deal. Get out, get in the truck. No judgments, but regardless of where you're coming from, you'd be forgiven for not fully understanding what financial repos are because most of us never deal with them directly. So what are they? Well, in short, they're a form of short-term collateralized loan. But as simple as that may sound, these instruments play a massive role in the US financial system, with an estimated two to four trillion dollars' worth of repos being traded every single day. Two to four trillion dollars. That's more than Canada's annual

gross domestic product being traded every single day. It's a massive sum, and given how much money flows through the system, it has huge implications for the rest of the market. And as we learned in 2019, a kink in the repo market can cause massive problems for the financial system as a whole. So let's go over what repos are, why they're so important, and why the Federal Reserve is involved with them on today's plane bagel. At first glance, the repo or repurchase agreement might seem kind of dumb. As the name suggests, it involves selling an asset and then buying it back, often times the very next day. Well, the repo may sound like that grifting scene in Community where students are passing around a suitcase for of seemingly no reason, the next lesson will be passing two briefcases. There is a method to this madness. Yes, that's two TV references. Now we're on a roll here. Repos are intended to function as a short-term loan where the asset being sold acts as collateral. Here's how it works. Let's say you're a financial

institution that's run into a bit of a cash crunch, and for one reason or another, you need 100 million dollars of cash in your account by the end of the day. So you decide to engage another bank or institutional investor who happens to have some excess cash on hand, and you enter into a repurchase agreement. You agree to sell the investors some of your treasury bonds that you have in inventory for 100 million dollars, and agree to buy them back tomorrow for a slightly higher price, let's say 100.01 million dollars. You expect to have some cash coming in tomorrow, so that should cover that by selling low and buying high. Good investment advice. I hear you are in essence paying an interest rate to the lender, the person who's buying the bond in the first place, because they get to keep that difference in the price. This implicit interest rate is known as the repo rate, and while it's baked into the repurchase price, the price that the treasuries are being bought back at, it's functionally the same as a regular loan.

interest rate. There's actually a formula for calculating what this rate is, which I'll show on screen. And if we use it for a rough example, you can see that the rate being paid is 3.6. But this is an annualized rate. The daily rate you're paying is much lower than this. So with our repurchase agreement, you, the bank, get your cash that you need to carry you over overnight so that you can meet your obligations. Well, the other party who's said to be entering a reverse repo agreement just because they're taking the other side of the arrangement. It's a quick and easy source of return for the money that they have excess on hand anyway. Piece of cake, right? But why do all of this instead of just getting a normal short-term loan or heck, actually selling the assets that you're pretending to sell in the first place? Well, to the first point, repos tend to be a very cheap form of debt because of the asset that's switching hands. For the lender, the treasury bond acts as collateral, extra security that

they'll get their money back from the arrangement if the borrower happens to default, and isn't able to buy back the asset as they promised. Then, the lender can gain possession and sell the asset to help recover their costs. This is also why repos are done with treasury bonds, and not something like a stock. The stock has a good chance of fluctuating in value from day to day, so the level of security that it would provide as collateral would waver, while treasury bond typically is a very slow moving and stable asset with low risk of default from the original lender, so it's a much better form of collateral asset. Even still, most repo agreements are actually over collateralized, meaning that the asset is sold and bought for less than the actual market value of the assets, with the difference being known as the repo margin or haircut. This just provides even more security to the lender, allowing them to make the loan at a very low interest rate. We talked about a repo rate above three percent in our example. Rival rates in the US are

actually around 0.05 percent on an annual basis, showing just how cheap this form of lending really is. As for why banks won't actually just sell their investment, that's usually because the bank doesn't want to lose exposure to the asset, even for just one night. The investment might be a strategic allocation that they plan on holding for the long term. It may also actually be easier and cheaper for the institution to do a repo arrangement than to actually sell the asset and then buy it back. So that's the lowdown on repos, and realistically, they probably don't sound all that important, but many have referred to the repo market as the plumbing of the financial system. As it helps to ensure that cash is where it needs to be every night for banks, which have vast amounts of money moving in and out every day, it helps ensure that they have the cash on hand to cover any near-term obligations. And for investors, it offers a quick source of return for the cash they have sitting around, allowing them to provide liquidity into

the market. The repo rate, as we mentioned, the market rate for these repo arrangements, also plays a pretty key role in setting other interest rates in the economy. The higher the rate, the more expensive it is for banks to get their own loans, and the more expensive other loans like mortgages or lines of credit are likely to be, demonstrating just how important this seemingly minor arrangement actually is and why things can get ugly when there's a kink in the system, something we saw in 2019 between September 16th and 17th of 2019. The repo market saw its rates jump as high as 10 percent, quite the shock considering it had historically averaged below two percent. All of a sudden, these low-risk short-term loans being taken out by the largest financial institutions in the world were more expensive than a consumer loan that an everyday Joe could get at their local bank branch. Now why'd this happen? Well, the prevailing theory is that the jump occurred as a result of a tax deadline for some of these

institutions overlapping with the settlement of some treasury debts events that ate up available cash and caused banks that were desperate for money to bid up rates in the repo market higher and higher. Eventually, the Federal Reserve stepped in to normalize things as many feared that this spike would translate into a liquidity crunch across the country. If banks could not access the money they needed, they might cut off or reduce their lending activity, causing rates to jump for other types of loans like we mentioned, and thereby slowing the economy. In fact, people were so spooked about the crisis that the Federal Reserve established more permanent open market operations within the repo market to help ensure that fluctuating rates with repurchase agreements didn't spill over into the federal funds rate, another rate for overnight lending that it tries to control. So, when rates get too high, the central bank will temporarily buy treasury bonds to inject money into the economy, and when rates are too low, they'll sell treasury bonds to take liquidity out of the system, albeit just for the duration of the agreements now.

for whatever reason, the terminology for Federal Reserve repos is opposite that of normal bank repos. In that, a Federal Reserve repo refers to the Fed buying bonds, while a reverse repo refers to them selling bonds. But outside this one detail, the process is more or less the same. And all this might sound like it doesn't really matter to the rest of us. I'd be willing to bet that most people didn't lose any sleep over the repo crisis of 2019. But remember, the rates that banks see will impact the rates we experience personally. So whether you've seen a direct impact or not from the repo market, it has had an influence on your personal finances. So that's the market, what repurchase agreements are, and why they're deemed so important. True, it's not one of the most exciting parts of the financial system, but with so much money flowing in and out of repurchase agreements every single day, and the Federal Reserve watching the rates so closely, you can see why it plays such a big role in the economy. Now we may hopefully never see

another 2019 repo crisis. But the next time repos find their way into a headline, at least you'll have a better understanding of what they actually are, assuming it stands for repurchase agreements and not repossessions. If you see a headline about a spike in repossessions, make sure to check your driveway for a big angry guy hooking up your car. It's going, it's gone. Hey, do you ever watch my videos and think, Yeah, Richard, I did have no idea about that event you were talking about, and I did think you were talking about a stage to reality TV show? Well, if you take that as an indication that you should maybe learn more about the world of finance, you should check out Morning Brew, today's sponsor, a completely free newsletter that summarizes all the big tech finance and business news in a really easy-to-read fashion. The newsletters are a quick five-minute read and will get you up to speed on the daily happenings. And with content being sent out seven days a week, there's

always something new to read related to today's topic. Actually, I recently read about the expected rate hikes in the US. Where the Morning Brew noted that even though rate hikes are considered a headwind for stocks, the S&P 500 has actually risen in 11 of the 12 Fed rate hike cycles since the 1950s, which sort of goes against our conventional understanding. I've personally been subscribed to Morning Brew for a while now, even before they were sponsored, and it's the first thing I read every workday because it's honestly the most entertaining thing I get to read at work, and the writers are really witty, so it's an easy way to start off the day. So if you'd like to join the Brew Nation, check out the link in the description below and start reading today. Don't worry, you'll still have time for your trashy TV. No hate, it just is what it is. Operation Repo was a trashy fake TV show. Thanks for watching.

Repos Explained (and Why The Fed Uses Them)

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I'm a CFA and CFP professional working as an analyst for an investment management company in Ottawa. I'm a huge finance nerd and am passionate about the field - I think people lack the resources they need to make educated financial decisions, and hopefully this channel helps with that!

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The videos on this channel are for education purposes only and do not constitute financial advice. Richard Coffin does not provide recommendations on The Plain Bagel - those looking for investment advice should seek out a registered professional. Richard is not responsible for investment actions taken by viewers and his content should not be used as a basis for investment trades.

Repos Explained (and Why The Fed Uses Them)

Repos Explained (and Why The Fed Uses Them)

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