Hi I'm Jimmy in this video
I'm going to walk through all the
craziness that's been happening in
the repo market.
I'm sure many of us have seen
headlines that look like this and
we may have also heard that this is
the Fed's first time stepping in
since before the Great Recession.
So our question is with this video
what's going on and how bad is this
for the economy.
OK so these are the two main
headlines that really sum up what's
been going on.
So basically to prevent there
from being a shortage of cash
the Federal Reserve has been pumping
cash into the banking sector.
So what we're going to do is look at
how this really works
and do we think it's going to be a
problem for the economy and how
similar are these actions to
what happened back in 2008
before the market crashed.
So repo is short for repurchase
agreement.
And here's the basics of how they
work. So every bank needs
to hold a certain amount of cash
every night to cover to cover
things like basic operations
or perhaps to meet regulatory
requirements.
Either way every bank is required
to hold a certain amount of cash
at the end of each night.
So what happens when one bank will
call them bank a they don't have
enough cash to
have enough cash to meet the
requirements overnight.
Well perhaps there's another bank.
Call them bank B and maybe they
have some extra cash.
And this is where the repurchase
agreement comes in.
So bank B agrees
to buy some collateral
in exchange for cash
under the condition that the seller
of the collateral in this case bank
agrees to repurchase that
at some agreed upon date.
Generally it's the next day.
Usually it's just overnight although
it could be a few days or even a
week or two.
But most of the time it's overnight.
So and this is the reason they call
it a repurchase agreement or repo
for short because they agreed
to repurchase it from
bank B.
So what happened at the start of
last week was that bank
B didn't want to lend
their excess cash or perhaps they
didn't have any excess cash.
So the Federal Reserve stepped in
and they bought the collateral
instead of another bank buying.
So when we hear people say
that the Federal Reserve is pumping
75 billion dollars let's say
into the system technically this
is true.
But the Fed is really
what's happening is the Fed is
buying the collateral for
the seventy five billion with the
agreement that the bank would buy
back from them.
Let's say tomorrow.
So this raises the question why did
the Fed step in for that we switch
over to this chart.
This is the Fed funds rate and I'm
sure many of us know that recently
the Federal Reserve has been
lowering interest rates and what
they ultimately try to set is the
Fed funds rate.
They've done it twice so far.
That's what those two all but
we may also notice from the
volatility here that although
this is where this is the rate the
Fed sets the market
can't adjust things.
If they want to that becomes more
obvious in this area.
But one interesting point that is
often overlooked is that ever since
2008 what the Fed actually
does is they set an upper target
for the Fed funds rate and they set
a lower target for the Fed funds
rate. So what we end up with
is sort of a channel for interest
rates. And then once they lower the
interest rates well once the Fed
lowers the interest rates the
channel drops as well.
OK. Simple enough but this brings
us to just recently when the repo
incident happened the rates
that money was being lent at jumped
over the upper bound of the
target rate.
And this was just the average.
Some banks are paying much higher
rates. Some are paying lower rates.
So at this point the Fed jumped
in and started lending money to the
banks since many
of the larger banks didn't want to
lend their money.
One of the primary reasons that I've
heard for the banks not wanting
to lend the money that they have or
being short on cash.
It was a timing issue with
they had to pay tax bills or
something like that.
Either way banks were hesitating
and because banks were hesitating to
lend the money what ultimately
happened was only a few lenders
only a few people willing to buy the
collateral and only a few banks
loan to buy the collateral.
And when the banks there were only
a few there are a whole bunch of
sellers and there were only a few
buyers. Supply and demand caused
interest rates in this case to start
to move higher in some cases
significantly higher to prevent
it from going over this line
by too much.
The Federal Reserve jumped in said
a more reasonable rate and they
started lending money.
And the Fed has this ability since
they have an unlimited supply of
cash since they can create it.
Well not really they can't really
create cash.
The Treasury creates cash but
the Federal Reserve can create bank
deposits.
So that's essentially the same
thing. So we're just gonna call a
cash since it's pretty much the
exact same thing now.
OK. So what does this mean
for the overall economy today.
And did this really happen before
the Great Recession.
Can this be a predictor of a crash
to come.
And the answer is yes.
It did happen leading up to the
Great Recession.
So do we think it's going to happen
again. Well yes.
At some point the economy is going
to collapse.
Do we think that this is the
indicator of the tipping point
that's going to cause that collapse.
Personally no.
But here's why.
The key to this whole thing is the
collateral that the banks put up.
So when the bank buys the collateral
from another bank.
Well technically that
those collaterals typically are
securities those securities are
supposed to be worth more than the
loan itself.
So let's pretend that I need some
cash. I turn to you and I say
could you lend me some cash.
I have some securities for you.
I want to use those as collateral.
You agree to buy those securities
from me at let's say ninety nine
dollars. And I agree to buy back
from you tomorrow for 100 dollars.
The extra dollar is your profit
for lending me the money.
Well that collateral
needs to be worth more than one
hundred dollars for this whole thing
to make sense.
Let's imagine that in this case the
collateral you're buying from me and
I'm going to repurchase from you
tomorrow is worth one hundred and
five dollars.
So if I don't pay you
tomorrow morning like we agreed
to. Well you wake up
you say you didn't pay me.
I'm going to sell the collateral for
a hundred five dollars.
You don't lose anything.
Now this is important because the
collateral the securities that I
sell to you for the repurchase
agreement are supposed to be liquid
securities that have an active
market. So going back to the Great
Recession what was the
dominant type of security that banks
were using as collateral in
the very very massive repo
market.
You guessed it mortgage backed
securities.
So when the real estate market
jumped off a cliff.
Well no banks wanted
to by the way over
leveraged mortgage backed
securities.
And the market tanks and the rest
is history.
Ultimately the government or the
Federal Reserve had to step in
and buy those securities
from the banks to allow for cash
to stay in the system.
A lot like what they're what they're
doing today except for one
major difference today
the collateral that the Federal
Reserve is buying from the banks
is mostly U.S.
Treasury.
And the odds of the U.S.
Treasury market tanking is far
less likely than it was of
the over leveraged mortgage market
back then.
So is this a concern
for the economy today.
Personally I don't think it's
an immediate concern although at
some point down the line it may
very well be a concern but for
now I think it's more of a
technicality.
And the Fed has been talking for
months about making this a standard
offer to the primary market
about permanently sitting there and
allowing for this to happen to keep
rates at a reasonable level as
a way of making sure that the
banking sector doesn't run short of
cash.
So at the end of the day at least
for the near term I don't think that
this is going to be the tipping
point that it sounds like it
could be based on what happened in
previous recessions.
But my question to you is do you
agree.
We all know that at some point the
economy is going to collapse.
It has happened over and over
in history and it always happens and
it always recovers.
Do you think that this is going
to be the thing that sends the
economy over the edge or
perhaps it's more likely
that eventually when the economy
tips this repo situation
is sitting on top of the whole thing
and adds a bigger burden for the
government to deal with at that
point. And in theory
could make things a bit worse then
please let me know what you think in
the comments below.
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