Repos: No Place to Run

Finally, an official gets it.

Six years, 848 pages, and 280 Dodd-Frank rules later, a Fed official is getting to the heart of the Financial Crisis. Eric Rosengren, President of the Boston Fed, gave a substantive speech about the repo market three days ago. Repos—or repurchase agreements—are a critical part of our financial infrastructure. They’re how major broker-dealers fund themselves. And Dodd-Frank barely mentions them.

In a repo, a firm sells a security and agrees to buy it back a day or so later at a slightly higher price. Because the sale and purchase happen simultaneously, the transaction is considered borrowing, not selling. The difference in the price is accounted for as interest. If the selling firm goes bankrupt, the lending firm has the securities as collateral.

Repos are widespread because they seem so safe. So safe, in fact, that when I was first learning finance, it was assumed that repo lines would always be there. After all, why worry about your borrowers when you have their bonds—and below their market price, too. The “haircut” is 2% for Treasury bonds, more for mortgages or corporates. But for some reason, lenders don’t like to deal with losses, even if their loans are secured. When times got tough in 2008, repo lending dried up. First Bear Stearns faced a run, then Lehman, then all the brokers had their credit lines cut. The Fed had to step in and backstop the banks, or we really would have had a financial meltdown.

Well, all the discussion about the Volker Rule and Living Wills for banks doesn’t address the simple problem that the big brokers use a huge amount of short-term borrowing to fund their long-term bond inventories. In fact, it’s striking how little has changed in their liability structures, and all that overnight money is still subject to a run. In his speech, Rosengren outlines some ways policy-makers could address the issue. Several—such has higher capital standards—seem pretty reasonable, although they would all impact profits.

Our global financial system is still vulnerable. The big broker-dealers were at the epicenter of the earthquake of ’08. Fixing how they finance themselves is long overdue.


Douglas R. Tengdin, CFA
Chief Investment Officer
Phone: 603-224-1350
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