Repurchase Agreements and Financing

In this chapter, the repurchase agreements mechanisms (repos) will be described and computations for the settlement of a repo transaction will be explained. By the end of the chapter, common motivations for entering into repos should be understood by the learner. Furthermore, the learner should be able to explain the arising of counterparty risk by applying the repo transactions.

The role played by repo transactions as far as the collapses of Lehman Brothers and Bear Stearns is concerned will also be assessed. There will also be a comparison of the application of general and special collateral in repo transactions. Moreover, the features of special spreads will be detailed and the typical characteristics of the special spreads of U.S. Treasury will be described based on an auction cycle. In conclusion, when applied in a repo transaction, a bond trading special’s financial advantage will be computed.

Repurchase Agreements: Structure and Uses

Securities can be traded at some initial price based on the fact that there will be a reversion of the trade at a particular fixed price at some given future date, through a contract called a repurchase agreement or repo. There are different reasons that have been cited by the different market participants for using repos. To compute the repurchase, consider the below situation:

Assuming that a counterparty \(W\) sells a $500 million face amount of DBR 4’s (Deutschland Bundesrepublik, or German Government Bond with a coupon of 4%) of May \({ 18 }^{ th }\) 2041, to a counterparty \(Z\), for settlement on June \({ 11 }^{ th }\) 2015, at an invoice price of $580.131 million. At the same time, counterparty \(W\) decides to rebuy the $500 million face amount four months later, for settlement on October \({ 11 }^{ th }\) 2013, at a purchase rate equivalent to the invoice price including interest at a repo rate of 0.31%.

Therefore:

$$ $580,131,000\left( 1+0.31\%\times \frac { 122 }{ 360 } \right) =$580,740,459 $$

The three reasons for doing repos are described by the following subsections: lending funds short-term on a secured basis, financing of long positions in a security, and borrowing securities in order to sell them short.

Repos and Cash Management

Investing in repos has been cited as an ideal solution to investors holding cash for the purposes of liquidity. The money market mutual fund industry, in which investments are on behalf of investors who are ready to accept relatively low returns in exchange for safety and liquidity, is the best example.

Repo investments have been known to pay a short-term rate in relation to super-safe and liquid non-interest-bearing bank deposits without significant default risk being incurred or much liquidity sacrifice.

Another crucial group of repo investors is municipalities. In order to have money on hand to cater for expenditures, cash surpluses will be run by municipalities from tax receipts since the timing of tax receipts does not have much to do with public expenditure schedules.

Risky securities cannot be used as investments for the said tax revenues. However, the collected tax should not lie handle. During the last financial crisis, most repo market lenders came to the realization that they were ill-positioned to possess and liquidate repo collateral.

Repo investors often lend overnight, because they place a premium on liquidity, instead of for term, which is any maturity longer than a day. In addition to interest rate risk, there is lending through term repos by investors willing to take on liquidity and counterparty risk.

Securities of the highest quality only are generally accepted as collateral due to the fact that safety is the other crucial consideration for repo investors, with government securities and debt issues from government-sponsored enterprises (GES) being the most popular choices.

Haircuts used by investors to ensure that the securities delivered by the borrowers are worth more than the loan amount are often provided in repo agreements.

Repo investors rarely care about the particular loan they should accept even though care is given to the quality of collateral that is acceptable. This implies that repo investors never insist on the receipt of any particular security within the delineated class despite the fact they can be very specific on the security classes they can accept as collateral.

Repos and Long Financing

The typical cash borrowers in repo markets are financial institutions. To make markets, the repo market is used by financial institutions to finance their inventories. Moreover, they can be applied to finance the institution’s proprietary positions and customer positions.

To explain repo for proprietary positions, consider a relevant trading desk as a counterparty with internal motivations to buy and sell bonds. On the other hand, repo for financing customer positions can be explained in terms of a customer as the counterparty who wants to finance the purchase of DBR 4s. The financial institution’s trading desk (the counterparty) does a repo with the client, lending cash and acquiring the DBR 4s as collateral. Then, another different counterparty, which provides the cash and acquires the originally supplied collateral, gets involved in a back-to-back repo with the trading desk. Practically, the haircut charged on each leg of the trade relies on the relevant counterparties’ creditworthiness but, in the absence of the haircuts, the cash amounts will be the same.

Reverse Repos and Short Positions

A bond can be short by professional investors by either betting that there will be a rise in interest rates or partly as a relative value bet that there will be an increase in the price of another security in relation to the value of security being sold.

Assume that a hedge fund is willing to sell certain DBR 4s. It will short the bond and, for it to make delivery, it borrows the bond from somewhere else. From the hedge fund’s perspective, a reverse repurchase agreement will be done, reversing the securities.

At a particular point in time, after the reverse has been initiated, the hedge fund will be ready to cover its short. The hedge fund will, therefore, purchase the bond and then unwind its reverse. Money will be made on an outright short position by the hedge fund if the repo rate of interest surpasses the return on the bond. Conversely, if the repo interest rate is exceeded by the return on the bond, money will be lost by the hedge fund on an outright short.

It is crucial to note that the delivery of a particular bond is necessary in reverses, despite the willingness by repo investors to accept general collateral. Repo transactions needing a specific bond to be delivered are referred to as special trades and they happen at specific rates of collateral.

Repo, Liquidity Management, and the Financial Crisis of 2007-2009

Since the 2007-2009 financial crisis, repo financing has been relied upon by broker-dealers less and less. There are many ways through which a financial institution can borrow funds, and some ways are more stable as compared to others.

Based on the fact that equity holders are not necessarily paid according to any particular schedule and they cannot compel a redemption of their shares, equity capital has been termed as the most stable source of funds.

Long-term debt, on the other hand, has been regarded as slightly less stable since the payment of bondholders’ interests and the principal is based on bond indentures.

With respect to the required expected returns by the fund providers, sources of funds that are considered as more stable are often more costly. Costs of funding can be balanced by managing liquidity against the risk of being caught without the required financing for survival.

There are relative liquidity and relatively low repo borrowing rates in the spectrum of financing choices. Naturally, due to its short maturities, the less stable side of the funding spectrum is repo, but it is more stable than short-term unsecured borrowing.

Tension between cash borrowers and lenders is created by the risks of repo funding together with those of repo investing, including difficulties for regulators. Prior to the 2007-2009 financial crisis, the lower-quality collaterals that were financed by borrowers ranged from lower-quality corporate bonds to lower-quality mortgage-backed securities at the available low rates and haircuts in the repo market.

These collaterals were accepted by lenders in exchange for somewhat higher rates than the ones available when lending on higher-quality collateral. During the crisis, the resultant expansion of accepted collateral for the repo worked out badly. This was especially the cases for borrowers who were unable to meet margin calls due to the declining values of securities and several other borrowers.

Collateral liquidations, losses, business failures, and capital depletion were the results suffered by the worst-hit borrowers.

Case Study: Repo Financing and the Collapse of Bear Stearns

The general mode of financing for Bear Sterns was borrowing funds on a secured and unsecured basis and using equity capital. In 2006, the amount of short-term unsecured funding (primarily borrowed commercial paper) was reduced.

The average term of its secured funding was increased substantially during the first half of 2007. Longer-term repos of six months or more were obtained to finance the company’s assets and generally limited its use of short-term secured funding for Treasury financing.

Instability was experienced in the fixed income repo markets approximately from 2007 to early 2008, as the duration of the loans was shorted by fixed-income repo lenders and borrowers were asked to post higher-quality collateral to support the said loans.

A run on the bank was suffered by Bear Stearns as a result of an unwarranted loss of confidence in the company by its customers and lenders. This confidence loss can partly be attributed to unfounded market rumors about the liquidity position of Bear Stearns.

This led to:

  1. Rapid and frequent cash withdrawals by prime brokerage clients;
  2. The declining of repo market lenders to roll over or renew repo loans, despite the loans being supported by high-quality collaterals; and
  3. A refusal by counterparties to non-simultaneous settle foreign exchange trades or, in simple words, a refusal to pay until Bear Stearns paid first.

Case Study: JPMorgan Chase’s Repo Exposure to Lehman Brothers

Borrower defaults and insufficient collateral values to cover the loan amount is the counterparty risk of lending money through a repo. When money is lent to a financial institution by investors via the tri-party repo system with collateral taken as the security, then the loans are overnight. Before the final week of Lehman, JPM’s tri-party lending to Lehman was more than $100 billion, and no haircuts were historically taken by JPM on its tri-party intraday advances until early 2008.

JPMorgan leveraged LBHI’s life and death power on the brink of their bankruptcy, as JPM’s primary clearing bank forced LBHI into a series of one-sided agreements thereby siphoning billions of dollars in assets that were critically needed.

By repeatedly demanding that LBHI increase the amount of posted collateral payments, LBHI’s desperately needed cash was drained by JPM.

Unlike any single tri-party investor, JPM took on a broker-dealer’s entire tri-party repo book daily. It was also discovered that most of the securities pledged by Lehman to JPM were illiquid, structured debt instruments that were apparently assigned overstated values.

But exposure to LBHI by JPM was increasing and it included exposure in areas not connected to third-party repo clearing. It was further discovered that some of the largest collaterals pledged by LBHI were not only illiquid and could therefore not be reasonably valued, but also largely supported by LBHI’s own credit. Amidst all this, enormous credit extensions were made by JPM to the struggling bank.

General and Special Repo Rates

Repo trades can generally be categorized as:

  1. Those using general collateral (GC); and
  2. Those using special collaterals.

In GC scenarios, although there might be precise specifications of broad categories of acceptable securities, the cash lender is willing to take any particular security. In the case of specials trading, in order to possess a particular security, the cash lender will initiate the repo.

For each bucket of collateral and each tempo term, there is a daily GC rate. GC trades are suitable for repo investors since they obtain the highest rate of collateral they are willing to accept.

Specials trades should be undertaken by traders willing to short particular securities and they must decide whether they can readily lend money at lower rates than the GC rates so as to borrow the securities.

On a specified date, a particular issue’s special rates are determined by the borrowing demand of the issue to that date relative to the available supply. Therefore, the demand and supply of borrow and lend issues is different from the demand and supply to purchase and sell issues.

There is a high demand to own a bond that trades rich as compared to neighboring bonds relative to the outstanding supply. Therefore, a prediction of the individual bonds’ special spreads is a tough task.

Special Spreads in the US and the Auction Cycle

Bonds of different maturities are sold by the U.S. government based on a schedule that is fixed. A 10-year on-the-run (OTR) security, for example, trades more special than a 30-year one. Due to the fact that there is a tendency by current issues to be more liquid, they have particularly low bid-ask spreads and trades of large size can be conducted relatively quickly.

Newly issued treasuries become ideal candidates for both long and short positions since they have extra liquidity. Most treasury shorts are for relatively brief holding periods. All factors remaining constant, the preference by holders of the said relatively brief short positions is to sell liquid treasuries, to recover them quickly and at a lower cost.

If a sacrifice is to be made on the liquidity by lending the bond in the repo market, compensation should be given to investors and traders who are long OTR bonds due to liquidity.

Similarly, traders and investors willing to short OTR securities display willingness to pay for the liquidity of the said bonds when borrowing them in them in the repo market.

Determining the bonds that trade special and also how special individual bonds trade over the course of the auction cycle requires the auction cycle.

According to observations, special trades are quite volatile on the basis of day-to-day, each day reflecting the supply and demand for special collateral. There is a tendency by the trades to be small after auctions and to peak before auctions, despite the fact that the cycle of the OTR special spreads is not regular.

There is a similarity between the behavior of the five-year OTR and that of the ten-year OTR. This implies that similar patterns are witnessed for shorter maturity OTRs although the spreads tend not to be nearly so wide. This is because shorter maturity Treasuries tend to be more frequently issued, hence preventing a particular issue from being the most liquid or the most favored short.

Both the term structure of an individual issue’s special spread and the historical data can be used to view the pattern of the special spreads.

Special Spreads in the US and the Level of Rates

It was only recently that penalties for failing to deliver a bond that had been sold were introduced. The implication is that, originally, the special rate could not fall below 0%.

Suppose a trader shorts the OTR 10-year but fails to deliver upon the settlement. The trader would forfeit the day’s cash and consequently lose a day of interest on the said cash.

If the trader borrows the bond overnight at 0% in the repo market in order to make a delivery, the economics of the borrow to the trader are similar as failing, since there is no interest earned by selling the bond in both cases.

Since the bond will not be borrowed by any trader because the special rates were 0% or less, the special rate should then always be more than 0%, and the special spread should not exceed the GC rate.

Due to the introduction of a penalty for failing to deliver, the penalty rate is the new upper limit for the special spread and not the GC rate.

Valuation of the financing Advantage of a Bond Trading special in Repo

As a result of their liquidity advantages, often OTR bonds trade at a premium. It is therefore crucial for special spreads to be translated into price or yield premiums.

The value of lending a bond in repo, borrowing cash at its special rate, and investing the cash at the higher GC rate is the bond’s financing value.

The assumption here is how special the bond will trade and the length of time taken by the bond to trade. The market view should also be accepted as expressed in the term structure of the special spreads.

The value of lending cash, say USD 98.5, at a given spread of 0.2199% for a period of time of 131 days, is computed as follows:

$$ USD\quad 98.5\times \frac { 131\quad days\quad \times \quad 0.2199\% }{ 360\quad days } =USD\quad 0.79 $$

This implies 79 cents per USD 98.5 market value of the bond.

Practice Questions

1) Suppose that DBR 4s with a face value of $100 million are to be sold by a counterparty to another counterparty for settlement at the price of $109 million. The counterparty selling the DBR 4s decides to buy back the $100 million face amount some 101 days later for settlement at a buying price equal to that of the invoice price with a repo rate of 0.26%. At what price can the counterparty repurchase the bond?

  1. $109.08 million
  2. $100.07 million
  3. $126.26 million
  4. $109.78 million

The correct answer is A.

The repurchase price is:

$$ $109,000,000\left( 1+\frac { 0.0026\times 101 }{ 360 } \right) =$109,079,509 $$

$$ \approx $109.08\quad million $$


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