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The Repo Man Cometh

Remember the gangster Paulie from Goodfellas? He’d be your partner and provide protection but it came at a cost. There’s a great scene where the character Henry Hill, played by Ray Liotta, sums up how it works to be Paulie’s partner.

“Now the guy’s got Paulie as a partner. Any problems, he goes to Paulie. Trouble with the bill? He can go to Paulie. Trouble with the cops, deliveries, Tommy, he can call Paulie. But now the guy’s gotta come up with Paulie’s money every week no matter what. Business bad? Fuck you, pay me. Oh, you had a fire? Fuck you, pay me. Place got hit by lightning huh? Fuck you, pay me.” – Henry Hill, Goodfellas 1990

Paulie was the ultimate repo man, you better pay him or he’s taking something valuable, perhaps even your life.

Repo men are a tough but arguably necessary part of society. There needs to be someone that will lend money, protection, or goods and have the guts to collect when things don’t work out well. In the last week you may have been hearing a ton of news about repo markets. Repo in the world of street finance is shorthand for “repossessed”. In the world of high finance it means “repurchase” but as I’m about to show, the street parlance of repossessed is a better description.

So what is all this confusing talk about repos in the market and the Federal Reserve having to help the repo market. I’m a fan of keeping things simple so let’s break this down in a few basic steps.

Step 1: Repo = short term loan

When you hear the word repo you should think short term loan. Like many loans in life, collateral is often required from the lender so that they feel secure lending out money. When money is lent between banks it is no different. Some banks will lend unsecured and when these loans are made they made at an interest rate that is reflected by the two largest indexes LIBOR and Fed Funds.

More common however is for banks to lend to each other on a secured basis where they require collateral to be pledged for safety. Typically that collateral is U.S. treasury bills and bonds. Why is it called repo then you may ask? The clever wizards of Wall Street, in their infinite efforts to thwart conservative management of their finances, disliked reflecting all their short term borrowings on their balance sheet as liabilities.

Before I go further you might be asking yourself, “Did I wake up in an alternate universe? Aren’t loans made to any business supposed to be a liability on that company’s balance sheet??”. To this I answer YES! Well…unless you’re a bank and then if you’re bank you can do some really magical things.

Step 2: How to disguise a short term loan

Banks figured out that rather than post collateral for their short term borrowings they could instead sell that collateral to the lender with an agreement to buy it back later at a higher price. Thus a repo is a repurchase agreement. Economically a repo is identical to a loan but legally it’s a sale and repurchase. If its a repo, then its treated differently than a loan on a bank’s balance sheet.

Step 3: Pay Paulie

So what happened last week is that Paulie came to collect and the banks didn’t have enough cash on hand to pay him. And you know Paulie’s motto. The banks all ran to the repo market at the same time with a bunch of collateral that they were trying to sell to each other. All of them had the same problem they needed cash to pay Paulie. This is what sent repo rates soaring and that’s why you heard about it in the news. See chart.

A few final comments. In the chart above we show repo rates in orange, Fed Funds rates in green, and LIBOR in purple. As a reminder repo rates show the rate for secured lending and Fed Funds and LIBOR are the rates for unsecured lending. As an astute market observer you may be asking yourself how and why a secured funding rate could be higher than an unsecured rate.

Logically, it should be the other way around. The Federal Reserve and everyone else is asking the same question and there’s lots of theories. We think the answer is simple, Paulie broke the knee-caps of short term funding markets. He knows that banks prefer to use their collateral to borrow cash, even if its at a higher borrowing cost, rather than reveal their true leverage by taking on unsecured loans where the liabilities are more transparent.

Today’s lesson? It should be obvious; make sure your bank isn’t doing business with Paulie.