Repo, or repurchase, agreements, are a popular tool with the Fed, which uses them to increase liquidity in the banking system. Repo agreements involve the sale of an asset with an explicit agreement that the asset will be later resold to the orginal seller, typically at a higher price. Such agreements effectively amount to super-collateralized loans, with the lender outright owning the collateral. The Fed makes great use of rep agreements as a short-term liquidity management tool. Agreements tend to be overnight, but may last as long as 65 days.
Q. Jim Grant was on earlier talking about the Fed, and this is a tool it uses frequently, right? First, what does “repo” actually mean?
A. The term is short for “repurchase”, and it describes a deal in which I sell you a security for cash, but at the same time get a contract to repurchase, or repo, it from you in the future at a higher price on a specific date. The difference in the purchase and sale price is essentially an interest charge. Therefore, a repo is essentially a super collateralized loan: your acting as a lender of cash to me, but during the term you own the security.
Q. OK, so now how does the Fed use repos?
A. It’s their favorite tool for adjusting the liquidity in the banking system, for increasing or decreasing the reserves held by the banks. If they want to increase those reserves, and make money tighter, they do a repo: they temporarily purchase securities—treasuries, agencies and mortgage-backed –, paying cash for them and so increasing bank reserves. This is temporary, of course, because when the repo term is up, they’ll take back the cash and return the securities.
Q. But what if they want to drain liquidity from the system?
A. Then they do just the opposite, called a reverse repo. They sell securities out to the banks in exchange for cash, so cash comes into the Fed and out of reserves.
Q. So, repos and reverse repos together give the Fed excellent tools for managing the level of bank reserves, but only for a short time, right?
A. Right, most are overnight, and the longest go out 65 days. If the Fed want to permanently add liquidity, it uses other tools, for example the outright purchase of securities which, of course, they did to a huge degree in the last crisis. That’s why its balance sheet is currently enormous.
Q. And are repos used by other institutions for other purposes as well?
A. Oh, yes, its an extremely common financing technique because, as we said at the top, its about the safest way to make a loan: you don’t just have a lien on the property securing the loan, you actually own it in the interim. Sort of funny when you think about it: all these sophisticated financial institutions have actually just adopted a version of the pawn shop model.