Repossessed – Scott Smith describes issues in the Repo Market

October 2014

By Scott Smith

The relative complacency in financial markets right now paints a picture of a healthy economic landscape. The S&P is up roughly 7 percent so far this year, and the Federal Reserve is assuring markets that lending conditions will remain accommodative even after the central bank has completed the expansion of its balance sheet. While the current bull market has been defined by the market’s ability to rebuff any negative external developments, as the old saying goes, “the devil is in the details” and at the moment the devil may be lying in an increasingly dysfunctional repurchase market.

Repurchase agreements (repos) act as a lubricant for the engine of financial markets, facilitating the ease of lending between two parties. Essentially, a repurchase agreement is the sale of securities by one party which comes with an expressed agreement for the seller of those securities to buy them back at a later date. In a well- functioning market, the repurchase price should be greater than the original sale price as the difference represents what is effectively a borrowing rate (repo rate.) The most common form of repos are when the initiating party sells government securities to another party, in exchange for cash and an agreement to repurchase those securities at a later date. The government securities (usually highly liquid U.S. Treasury notes) act as collateral for the loan, and allow the original seller to increase their leverage and put that cash to use in search for higher yield.

Read the full article (pdf) at: AFP – Scott Smith, Senior Market Analyst describes issues in the Repo Market