I read this article on Bloomberg.com about the growing number of failed Repos and the growing demand for treasuries. I can’t seem to connect the dots between failed repos, treasury demand, and owners of treasuries getting paid to lend out their securities. http://www.bloomberg.com/apps/news?pid=20601103&sid=anf.Bv7jZkTM&refer=news
It’s a game. Suppose that I go out and make a deal with you to lend me money at an annual 0.1% rate for a week collateralized by a bond. The worst thing that can happen to me in this deal is that I owe you one week’s interest. I can call you on the phone and say “I was just kidding. I don’t have a bond. Your mother looks good in socks. See you” and then send you the 0.1% interest on the loan at the end of the repo period. But in the meantime I have an option to borrow at 0.1% interest for a week (or any portion of the week until the end of the repo period). It might be that the option + keeping possession of the bond is more valuable than 0.1% interest I would pay if I fail to deliver the bond. The problem of course is that the repo market is the way that people get possession of those bonds for temporary purposes like covering short positions. A delivery failure can be a really pain in the a$$.
So for those people who are borrowing money on the repo market, there is little penalty for not returning the security, and because the opportunity cost is so low they’ll just keep the treasury? But if you have to mark-to-mark the treasury wouldn’t you be exposed to interest rate risk?
It’s not about not returning the security. It’s about showing up with a security in the first place. Basically, I arrange the repo loan and then fail to settle the trade. I can arrange to get a repo loan without actually owning the securty I say I am going to deliver. Anyway, remember that in a repo, the person with the bond maintains ownership of the bond so if you own the bond the amount of interest rate risk you take on does not depend on whether you repo it or not.
Oh, so when you enter into a repurchase agreement you don’t actually have to give the counterparty the collateral when you take their money. The fails stems from the fact that financing rates are so low. Basically people are just lying to each other in the repo market inorder to get cheap financing. Thanks for helping me understand the process JoeyDVivre.
BiPolarBoyBoston Wrote: ------------------------------------------------------- > Oh, so when you enter into a repurchase agreement > you don’t actually have to give the counterparty > the collateral when you take their money. When you take their money you do, but prior to taking their money you don’t. You always have the option to complete the repo agreement by showing up with the bond. They have agreed to lend you money so they would be in breach if they didn’t honor the agreement. > The > fails stems from the fact that financing rates are > so low. > Yes > Basically people are just lying to each other in > the repo market inorder to get cheap financing. > Cheap options, actually. “Lying” is a little harsh here. They are honoring a flawed contract that is only flawed when the world is messed like it is now. We had negative repo rates from this stuff back in 2003. > Thanks for helping me understand the process > JoeyDVivre.