Since September 2019, The Federal Reserve has cranked up its repurchase agreement operations(Repo), after a period of dormant activity. In the recent past, since 2009, The Fed was engaging in more Quantitative Easing(QE). As a result, the Fed has been buying back the cash from the banks as a means to offset the QE.
While you are reading this, you maybe asking yourself: “What is this jobberwocky regarding repurchase agreements? Why should I care?” Both are excellent questions, and they deserve an answer. For starters, let’s discuss the concept of a repurchase agreement.
The Pawn Shop Transaction
Imagine you are short on cash, and you have some urgent expenses that require your immediate attention. Let’s assume, for this example, the amount needed is $1,000, and your next payday is in 7 days. You are feeling anxious. However, you begin to rise out of your lugubrious mental state, and you recall that you own a fine musical instrument. Bubbling over with excitement, you scurry over to the local pawn shop, hoping to get some cash to help you in your current plight. You enter the pawn shop, and you are shocked to the fact they can give you the $1,000 for the instrument. But, you suddenly realize: There is no free lunch. The pawn shop operator reviews the condition of the instrument, as he checks to see if its value is worth the exchange. The pawn shop operator agrees to the deal, but you must pay him back $1,300 in a week. The pawn shop gives you the cash, which helps your cash position for the short period until the next payday. In the exchange, the Pawn Shop takes control over the Musical Instrument.
You are okay with these terms despite the interest rate charged because you really need to cover these urgent expenses. In a week, you pick up the instrument and pay back the pawn shop $1,300. The $1,300 represents the original amount plus interest. If you never payback the Pawn Shop, then the shop keeps the Musical Instrument. Most likely, in this hypothetical scenario, the musical instrument is worth well more than the $1,000. The pawn shop’s risk is mitigated by following: (1) their proper valuation of the instrument, and (2) the interest charged to you for your repayment.
A Repo: The Pawn Shop Transaction…with a twist
A repurchase agreement works in a similar fashion, but there is a slight twist: The ownership of the collateral does change hands, but there is an agreement for the receiver of the money to purchase back the asset in a short period of time. The assets sold, in the repo, can be US Treasuries, Mortgage Backed Securities, or the like. The Federal Reserve will provide the bank the cash for the asset. The bank agrees to purchase back those securities at a later date, for a higher price. That buy back price is driven by the Federal Funds lending rate, which is established by the Federal Reserve. Side note: That rate is the amount used to factor how much interest to charge when banks borrow from each other. Once this occurs, the bank has more cash on the balance sheet. A reverse repo is simply the opposite transaction, from the bank’s perspective. The Fed will simply sell to the bank those assets/securities, in exchange for cash.
Why would a bank engage in a Repo transaction with the Fed? For starters, this helps maintain the proper cash reserves for the bank. Next, since the Federal Reserve sets the Federal Funds lending rate, perhaps the bank can take advantage of some arbitrage opportunities. A conceptual example to consider: If the funds rate is 1.75%, perhaps the bank feels it can earn 2.00% on another investment. Another reason: A bank could have liquidity issues from a group of loans that have defaulted, and they lack the cash to move forward. The reasons to enter a repo with the Fed are not limited to simply a few. With any economic transaction, there are costs, and the repo transaction is not immune to this.
Concern One: Moral Hazard
The concerns regarding these transactions can be many, I will simply cover two. First, since the Federal Reserve acts as “The Lender of Last Resort”, this repo transaction acts as a moral hazard. The banks can engage in all sorts of risky business knowing that The Fed is going to bail them out. If the banks decide to invest into a bundle of a certain type of investments, and that tranche goes sour, their liquidity is compromised. The Fed can come in, engage in a repo agreement, and liquidity is restored. If banks had no “safety net” for their investing behavior, they would be forced to moderate their investment risks accordingly.
Concern Two: Inflation
Once the funds are injected into the banking system, this expands the money supply instantly. With inflation, the economic value of the currency drops as each piece of the monetary unit is added to the money supply. Since banks operate with a fractional reserve model, once the funds are given to the banks, they show higher cash reserves on their financial statements. For example, a deposit of $1.00 can be expanded to show $10 on the bank’s books. Imagine that with billions of dollars. That becomes massive.
As with all inflationary measures, the first recipients of the cash are the main benefactors. In this case, it is the banks. The interesting thing about inflation: It acts as another tax on everyone else, mainly savers and individuals on a fixed income. A few benefit from the expansion of the money supply, and the economic cost of this monetary expansion is spread all throughout the rest in society.
Why Should You Care?
If you are on the quest of building wealth, knowledge about the financial world around you is important. With regards to monetary policy, and even fiscal policy, it impacts your ability to build and accumulate wealth. The insidious combination of loose monetary policy, and the federal government spending at egregious levels, makes it increasingly difficult to save and build wealth.
With the expansion of the money supply, it can develop asset bubbles. In the last 2O years, we have seen two different bubbles burst, due to loose monetary policy. With both bubbles, the warning signs were there, many continued with their investments and lost. If the investors who were wiped out could see the signs, perhaps things could have been different.
With the expansion of repo operations, the Fed’s balance sheet continues to grow. Some traditional economists may see this as necessary due to the fact the Fed must be able to maintain and smooth out the economy when needed. This activity comes with a tremendous cost, as individuals are feeling the squeeze of inflationary risk. Something to consider: Inflation is not really about prices rising, but it’s more about the monetary base being devalued. Since it takes more monetary units to by more goods, it gives the illusion that goods prices are rising, when it’s really the fact that the currency is loosing value over time. This is the surreptitious nature of inflation as it relates to these sort of central bank policies.
Here is an article ink that covers this matter in more detail. It also provides graphs of the Federal Reserve’s balance sheet mix comprising Treasury Bills and Mortgage Backed Securities. The ratio blend of these assets fluctuate daily, as repos can activated and unwind overnight or in weeks. The point is the growing balance sheet, as it relates to the Fed’s increased activity with repo operations. The link: https://wolfstreet.com/2019/12/05/fed-goes-hog-wild-with-t-bills-but-repos-drop-from-a-month-ago-and-mbs-shrink-by-22-bn/
The Federal Reserve website providing an explanation of asset balances: https://www.federalreserve.gov/releases/h41/current/default.htm
An article describing the renewal of the repo operations: https://mises.org/wire/ghosts-failed-banks-have-returned
How the Fed has Boxed themselves into a corner, as they did before the Housing Market crash: https://mises.org/power-market/3-charts-showing-just-how-boxed-fed