Amateur Hour at the Repo Corral

Kevin Drum asks for help interpreting a recent spike in repo rates: 
What’s Wrong With the Repo Market?

To be clear, I am an amateur, and hence the title of this post.  Anyway, first I'll post Kevin's issues and then my amateur response.

Kevin is somewhat mystified:

nothing to see here, just the odd confluence of a bunch of technical factors all at the same time. It’ll blow over pretty quickly. 

Which might be true. It’s certainly above my pay grade to analyze this. Still, the whole “technical factors” explanation has a whiff of post hoc bullshit to it, especially considering that this emergency started very suddenly right near the close of business on Monday. It seems like somebody needed a whole lot more cash than they had anticipated, and for some reason other banks were reluctant to lend it. Maybe that’s because the other banks really were short of cash. But it might also be because they knew who the counterparty was and they were afraid that even a 12-hour loan ran the risk of not getting paid back. It’s the kind of thing that happens during a banking crisis—which, as it happens, is the last time the Fed had to intervene in the repo market. 

I don’t mean to go all grassy knoll on this. I suppose it’s more than likely that this really was just a weird coincidence that will be cleared up shortly. But it’s worth keeping an eye on. For now it’s just a mini-mystery.

Here is my take, in the form of a long version and a short version.

SHORT VERSION FOLLOWS:

The repo market is very safe since it generally involves the swap of one form of government liabilities (central bank reserves) for another (government debt), with at most one day duration risk.  Occasionally, even this tiny duration risk can throw markets out of balance temporarily if, for example, government debt yields are rising quickly as happened over the last week.  In this case, traders, exacerbated by computer trading algorithms, would prefer not to acquire government debt until the market quiets down.  The central bank can step in and purchase bonds via repo agreements to fix things, and this is apparently what happened in the last day or two.  Thus, the problem was very short term and easily fixable by the central bank, i.e. "technical".

Private debt liquidity issues are more serious in that they are not generally fixable by the central bank, as the central bank should not buy private debt except in extraordinary circumstances.  When there are private debt problems, the price of government debt goes up in a flight to safety.  This what has happened over the past year as the 10 year yield, for example, crashed from 3.25% to 1.5%.  The resulted in an inverted yield curve, a reliable indicator of problems with the financial system. 

LONGER VERSION FOLLOWS:

U.S. government liabilities consist of central bank reserves and U.S. Treasury bills and bonds. Repo operations provide overnight liquidity as needed, converting bills and bonds to reserves. The overnight repo rate can go up when there is a sudden increase in demand for liquidity and/or a surplus in the supply of bonds / bills offered for lending (or short term repurchase). When that happens, the central bank can step to buy up bond/bills via repos, which is apparently what happened the other day.

Net government liabilities are equal to net private sector assets and consist of time deposits (government debt -- bills, bonds) and demand deposits (reserves). The total amount of this "money" supply is determined by fiscal deficits over time (although the central bank occasionally creates more of this "money" by buying private debt such as mortgages). The government interest rates are managed by the central bank which buys and sells government debt.

The private sector also creates money, of a different and less reliable sort, via debt issuance. Bad private debt is common, and liquidity issues result. These generally don't affect repo operations, in my opinion, because repo uses government liabilities as collateral and therefore is extremely liquid. A more likely possibility, in my admittedly non-professional view, is that there may be a surplus of government debt offered to the repo market on days when people (or computer algorithms) think the price of this debt will fall. Buyers of this debt (repo suppliers of cash reserves) demand higher interest rates because of the risk of the collateral price falling.

As others have said, it seems like a short term glitch, unrelated to fundamental liquidity issues. Fundamental liquidity issues are more reflected in the price of government debt, which has been going up (interest rates going down) massively over the last year. So money is tight, liquidity is a concern, but repo spikes are irrelevant.


PROFESSIONAL FEEDBACK from KinersKorner:

Some good stuff there.  The price of the underlying  collateral is irrelevant in the day to day operations of repo.  Margin moves via FICC.  Only risk in repo is counter party risk, mitigated by fully priced Govt securities and shared countered party risk by FICC members. Customer repo is a different story but they pay big margins to get financed.  This was and still is purely technical.   Not at all like 2007 when Bear Sterns was going belly up.  Heck they didn’t even move the market like this, nor did Lehman. Another thing that may be contributing could be balance sheet restrictions.  In the past Fed Funds Rates  would rise with repo rates as traders moved money from that market to repo.  Since no one seems to trade anymore the profit opportunity sits with no takers. 

and from Wikipedia:

• Fixed Income Clearing Corporation (FICC) – Provides clearing for fixed income securities, including treasury securities and mortgage backed securities^[37][38]

FICC was created in 2003 to handle fixed income transaction processing, integrating the Government Securities Clearing Corporation and the Mortgage-Backed Securities Clearing Corporation. The Government Securities Division (GSD) provides real-time trade matching (RTTM), clearing, risk management, and netting for trades in U.S. government debt issues, including repurchase agreements or repos. Securities transactions processed by FICC's Government Securities Division include Treasury bills, bonds, notes, zero-coupon securities, government agency securities, and inflation-indexed securities. The Mortgage-Backed Securities Division provides real-time automated and trade matching, trade confirmation, risk management, netting, and electronic pool notification to the mortgage-backed securities market. Participants in this market include mortgage originators, government-sponsored enterprises, registered broker-dealers, institutional investors, investment managers, mutual funds, commercial banks, insurance companies, and other financial institutions.

AND MORE PROFESSIONAL FEEDBACK from KinersKorner:
It’s a completely esoteric market that is more like plumbing then Wall Street.  It matches well daily and there is risk trading involved by Wall St but it is interest rate risk like any fixed income security.  Only other problem I see is too my knowledge there are zero repo algorithms.  It’s still a human market.  A large % of O/N specials  are mostly traded on electronic broker screens  by humans.  Specials just means when dealers are short or long specific treasury issues.  The rate that spiked was the o/n general collateral financing rate, which of course drags every other o/n rate with it.  As to who the buyers are- think money market funds ( with money), sellers think primary dealers (with collateral that needs to be financed). For the uninitiated- nobody on Wall St actually owns treasuries.  They go long but finance them. 

UPDATE 10/16/2019: https://wolfstreet.com/2019/10/15/why-banks-didnt-lend-to-the-repo-market-when-rates-blew-out-jpmorgan-ceo-dimon/

COMMENTS BY ME ELSEWHERE:
I guess somebody needed cash and was stuck with Treasuries, and Saudi Arabia makes sense as a big player that might be in that position.

My conclusion is that the repo action is basically a nothing burger. Repo operations are just one day exchanges of central bank reserves for U.S. bills and bonds. The central bank routinely swaps such "debt" (time deposits) for reserves (demand deposits). When the private money markets have trouble doing this, the central bank can step in, which is what they did the other day. Problem solved.

There may be problems with private debt and private money markets, separate from the repo market in government securities.
More commentary at https://www.nakedcapitalism.com/2019/09/the-fed-has-not-covered-itself-in-glory-fed-funds-edition.html
Key point: Because of the inversion of the yield curve, people and institutions can get higher interest via short term Treasuries or repos, than they can from long term Treasuries.  This applies to foreign countries trying to weaken their currencies and build up "reserves" (in a different sense) also.

The following quote is in regard to the Fed using interest on reserves in place of the Federal Funds Rate to manage short term interest rates.

It looks worrisomely like the Fed hadn’t thought through the second-order consequences of its post-crisis changes, and some of them are now coming back to bite. No wonder some bankers are calling for the Fed to institute a two-week repo facility. Even though the Fed has the means to tamp down these problems, the failure to do so expeditiously and well is a dent to its credibility.

From the comments:

timbersSeptember 20, 2019 at 7:43 am

I asked Wolf Street what was up with this repo snafu, as I did not recall ever hearing about something like this.

As I understand his response, is that the Fed did this routinely pre-massive QE/financial crisis. But as QE flooded the system, it became less needed if at all.

Today with massive QE gone (for how long who knows), it’s come back.

This might partially explain the Feds learning curve.

And some quarters have been quick to give it a spin that may not be accurate…like it’s stealth QE returned or a sign of upcoming big financial crash.