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.
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| 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.
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| 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).
#30#
