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U.S. Treasuries and “Repos”

When Standard & Poor’s warned it would lower the U.S. government’s AAA credit rating by one or more levels even if Congress raised the debt limit in time to avert a default, all sorts of dire predictions were made about the monetary system.
One predictions was that if Standard & Poor’s lowered their rating to AA+ that such an action would “modestly raise” the federal government’s borrowing costs. That did not happen.

Another prediction by Fitch Ratings was that “As money market funds hold approximately $1.3 trillion in U.S. Treasuries, nearly half of their total $2.7 trillion in assets, investors would probably be spooked in the event of a default by the U.S. government and rush to the exits to redeem their shares.” That did not happen.

Remember the opposite happened when Standard & Poor’s lowered their rating. There was a rush to buy U.S. Treasuries and borrowing costs were lowered. U. S. Treasuries are still seen as one of the safest investments in the world.  So much for predictions.

But it is interesting that people were worried about it. And it led me to wonder about the market’s fears. I have questions about all the borrowing that goes on withU.S. Treasuries and their relationship to “repos.” Before this discussion, let me say this -

I would submit that the financial crisis was not caused by homeowners borrowing too much money. It was caused by giant financial institutions borrowing too much money, mainly on the “repo” (repurchase) market.

Have you ever heard of the “repo” market which is one of the largest markets in the world?

First, let’s talk about U.S. Treasuries. The United States government borrows money through issuing Treasury securities which come ion four types, short-term treasury bills (T-bills), Treasury Notes (one to ten years), Treasury Bonds, (20 to 30 years) and TIPS (Treasury Inflation Protected Securities for 5, 10, and 30 year maturities.

The Repo Market uses U.S. Treasuries. Repos is short for repurchase agreements between large institutions which loan money to dealers usually overnight. Let’s say that you are a large company and you have $20 million that you don’t need until tomorrow.  You make a deal with a dealer that has borrowed money in the form of U.S. Treasuries from a cleaning bank. The deal might be 5% for the use of your $20 million overnight which amounts to $2777.78 for the company. The dealer uses the company’s money overnight and repays the company in the morning with interest. The dealer is an intermediary between a clearing bank and a large institution which has big bucks for a few hours – corporations, banks, state and local governments. All sort of institutions use the repo marker, usually overnight.

What happened in September 2008?

“What happened in September 2008 was a kind of bank run. Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market.” –Robert E. Lucas, Jr., Nancy L. Stokey, visiting scholars, Federal Reserve Bank of Minneapolis, May 2011.
That is why a possible default of the U. S. Government is such a big deal. It is the fear factor. Any decline in the value or the liquidity of U.S. Treasuries would result in increased margin calls which pressures the overall availability of funds in the repo market. What if the dealer could not repay the company in the morning? What if that happened all over the country? That was September 2008.

Repurchase agreements (repo) are the largest part of the ’shadow’ banking system: a network of demand deposits that, despite its size, maturity, and general stability, remains vulnerable to investor panic.” –Jeff Penney, senior advisor, McKinsey & Company, June 2011.

Professor Gorton talked about Repos’ flaws: “Repo has a flaw: It is vulnerable to panic, that is, ‘depositors’ may ‘withdraw’ their money at any time, forcing the system into massive deleveraging. We saw this over and over again with demand deposits in all of U.S. history prior to deposit insurance. This problem has not been addressed by the Dodd-Frank legislation. So, it could happen again. The next shock could be a sovereign default, a crash of some important market — who knows what it might be?” –Gary B. Gorton, Professor of Management and Finance, Yale School of Management, August 14, 2010.
Look at http://repowatch.org/

Unfortunately, there has been little attention paid to the Repo market; it is too big to be unregulated without controls. Could it happen again? Yes, it could happen again. Large institutions could get scared and want their money back and dealers may not have the funds at that moment.

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