How the Repo Market Affects Your Interest Expense
You may think of a repo as that guy coming to take (repossess) your car because you failed to make a few payments. What about a reverse repo? Is that when the repo guy gives you your car back because you caught up on your payments? The car is the collateral, and the borrower pays interest on the loan used to purchase the car. Once you pay off the loan the collateral is yours.
What’s a Repo?
In the financial markets, a Repo (Repurchase Agreement, not repossession) is a contract between those who need cash and those who don’t. In a Repurchase Agreement (Repo), Party A is the borrower and Party B is the lender; and Party A secures its loan by providing securities to Party B as collateral. In a Reverse Repo, Party A is the lender and Party B is the borrower; and Party B provides Party A with securities as collateral. At maturity, the agreement is settled by the borrower returning the cash plus interest to the lender, and the lender returning the securities to the borrower.
Trillions of dollars worth of Repos are traded every day by banks, non-bank financial institutions, money market funds, and the Federal Reserve. It is the most widely used method of providing short-term cash financing for those who need liquidity. The Repo market is the critical support necessary for a working, efficient, and functioning capital market.
Repos and Reverse Repos are the main mechanism used by the Fed to control the money supply. They do so by borrowing securities and lending cash or lending securities and receiving cash in exchange. A lower Repo rate encourages banks to lend securities to the Fed in exchange for cash which increases the money supply. The Fed can also lend securities (Reverse Repo) to suck up cash to decrease the money supply. This allows the Fed to maintain the federal funds rate – an interest rate that’s highly correlated with 1-month LIBOR, the dominant floating rate index used in floating rate loans – within a targeted range.
Repurchase Agreements provide a functioning and liquid short-term debt market, which is critical to the stability and wellbeing of the economy. There are many types of Repo’s, but the one to understand is the Repurchase Agreement where U.S. Treasuries are used as collateral (the risk-free rate).
Why care about Repos?
The short answer is SOFR. SOFR (the Secured Overnight Funding Rate) is the heir-apparent to replace LIBOR in the coming months. It is a gauge of the cost to borrow funds overnight, collateralized by U.S. Treasury securities. But wait, you say, that description sounds alot like a Repo. Exactly. SOFR is calculated using a volume-weighted median of transactions in the overnight Repo market.
If you haven’t seen SOFR show up on a loan term sheet yet, you will soon. Freddie and Fannie are already using it as the floating interest rate component in their adjustable rate mortgage offerings. More and more banks are doing the same, and many bridge lenders aren’t far behind.
Proponents of using SOFR as a replacement to LIBOR laud the index as being “un-manipulatable”, since it is calculated using actual market transactions with daily volumes over $1 trillion. SOFR is also appealing as the Repo market (the basis of SOFR) has basically replaced the dwindling Fed Funds market (the basis of LIBOR) as the Fed’s mechanism of choice in managing its Fed Funds rate; the rate the Fed hikes or cuts in its monetary policy activities.
As illustrated in the chart below, Repo Rates (and thus, SOFR) have also been subject to some extraordinary, but regular, spikes caused primarily by large cash liquidity events such as corporate tax payment dates and U.S. Treasury refundings. It is important to note that these spikes have no relation to any credit events or economic trends, but are purely caused by the short-term supply, or lack thereof, of cash in the markets. As a borrower, how would you feel if your commercial loan interest rate, indexed to SOFR, happened to be reset on the day of one of those dramatic spikes?
Historical Repo vs. SOFR
Source: Bloomberg Professional
Counter to the SOFR proponents mentioned above, SOFR skeptics question the index’s claims that it can’t be manipulated, like what was seen in LIBOR over the last decade. These SOFR skeptics argue that the spikes described above are evidence that the Repo market, and thus, SOFR, can indeed be manipulated, or at a minimum, subject to high, unexplained volatility uncorrelated to underlying economic activity and stated Fed targets.
Here’s a recent article that takes the pulse of the current state of the Repo market. It’s worth a read: Banks Weigh Alternatives to Libor Replacement as Companies Seek Longer-Term Rates – WSJ
As a borrower, you should easily be able to answer the following questions. Can you?
- Why should I be concerned when there is an unusual dramatic spike in lending through the repo market? Is this the Canary in the Coal Mine to a rough economic time to come? High volatility is a sign of instability. The longer the Repo market is volatile the more unstable it becomes.
- Why hasn’t SOFR not moved from 0.05% since June 17, 2021? In contrast, why has the overnight Repo rate, a broader version of SOFR, fluctuated during during the same period and even briefly went negative? Could SOFR trade below 0.00%? Could SOFR go negative? How would such an event impact my interest expense?
- As they move away from LIBOR, some lenders have announced they will be using a Credit Sensitive Rate (CSR), like BSBY or Ameribor instead of SOFR as a LIBOR replacement. Why is my lender planning to use a CSR benchmark instead of SOFR as a replacement to LIBOR? Why?
- What are the risk factors if my loan is tied to SOFR or a CSR when there is a disruption in the credit or Repo markets? What would such an event mean for my interest expense?
- By the end of 2021, LIBOR-indexed loans (loans and swaps) will no longer be available. At the end of June 2023, banks will no longer be required to submit LIBOR quotes. What will this mean for my loan? My interest rate swap? My rate cap?
Stumbling with your answers? You’re not alone. Most borrowers – and lenders – are playing catch up in acquiring knowledge about how the ongoing changes in interest rate markets will impact their debt portfolio.
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