In 1984 a film came out that has achieved “cult status” and is still considered one of the best films released that year: Repo Man. The film stars Harry Dean Stanton and Emilio Estevez, and the executive producer was Michael Nesmeth, as in, “Hey, Hey, We’re the Monkeys” Nesmeth. It’s about a couple of guys trying to repossess an automobile that seems to be connected with extraterrestrials.
|Who says cars don't kill people?|
That’s not what we’re going to look at today. Instead, we’re going to offer a brief commentary on an article that appeared in yesterday’s Wall Street Journal . . . that at first glance we thought had something to do with repossessing automobiles and immediately called the film to mind.
Today’s topic, therefore, is a response to the article “To Make Banks Stable, End, Don’t Mend, the Repo Market” by Amar Bhidé of Tufts University. What is involved in this case is not necessarily or even usually automobiles, but collateral used to secure a loan.
“Repo” is short for “repurchase agreement.” A repurchase agreement is a transaction used to finance ownership of bonds and other debt securities. Typically, a dealer will finance the purchase of a bond by borrowing money overnight and posting the bond itself as collateral. Banks also use repurchase agreements to raise quick cash or to invest excess cash for a very short time, e.g., twelve hours.
Obviously, things can get a little crazy. The idea is not to have one cent of idle cash lying around. Naturally, if the interest rate charged on an overnight loan is less than the interest rate of the bond being purchased and then used as its own collateral, the repo market can be a very happy hunting ground for speculators. They can purchase a bond that yields 3% on credit, and pay for it with a loan at 2.99% secured with the 3% bond. (We deliberately used such a miniscule difference in the interest rates to show how even tiny differences can make speculators rich at almost no risk.) If the bond is sold as soon as the loan to purchase it comes due in twelve hours, the speculator pockets 0.00001389% profit on the deal.
|Not much of one, though. . . .|
That does not sound like a very big profit . . . but remember, we’re not talking measly little bonds of $100,000 or so. We’re talking millions, billions, and sometimes trillions. A repo for a $1 million bond for twelve hours — and in today’s markets, $1 million is peanuts — would yield 13.89¢ (using the Julian year). Not much, but multiply that times 100, and it turns into $13.89.
Still not enough to tempt any gambler; the effort isn’t worth all the trouble, although it could be very attractive to a bank that needs a sudden infusion of cash and doesn’t want to go to the Federal Reserve. Instead of paying interest to the central bank, the commercial bank can break even or pay much less than the Federal Reserve would charge.
Let’s change the difference in interest from 0.01% (which is ludicrous, anyway), to a full 1% . . . and remember that the interest rate arbitrage on repos last month went as high as 8% in a “seismic” spike in repo interest rates. Sticking with the 1% difference, a speculator would make $1,388.89 on a twelve-hour $100 million deal. That’s $2,777.78 each day — the market is global, so “overnight” is available 24 hours a day, seven days a week, but we’re being conservative. That’s $1,013,889.70 per annum, all without putting up a cent of your own money. You don’t even need an office. Just a telephone or a computer.
The problem, of course, is that the whole repo market relies on there being a good supply of “safe” government debt to deal in as collateral, and that means a sound private sector economy to support poor fiscal management on the part of government . . . which cannot be sustained unless the government stops going into debt!
Under Just Third Way reforms, all new money would be backed by private sector loans to finance new capital or secured by existing inventories of marketable goods, NOT government debt backed by future taxes that might never be collected. Government debt would be paid down, eliminating not merely government bonds as the backing of the money supply, but the entire repo market. Instead of pledging government bonds as collateral, businesses would use insurance policies that paid off in the event of default (and there are ways to secure against defaulting on loans just to get the insurance).