Repurchase Agreements and Financing

(Chapter 12)

2011 by Bruce Tuckman. All rights reserved.

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Outline
Repurchase Agreements Uses
Cash Management Long Financing Reverses and Short Positions

Liquidity Management and the Financial Crisis

The Collapse of Bear Stearns JPMs Exposure to Lehman Barclays, JPM, and the Fed in Sep 08

Outline, cont.
General Collateral Repo Rates Special Repo Rates
The Auction Cycle The Level of Rates The Financing Advantage of a Bond

Repurchase Agreements

Repurchase Agreement: Initiation

Repurchase Agreement: Example

Repo of 100mm DBR of January 4, 2037
Counterparty A borrows cash / lends DBRs. Counterparty B lends cash / borrows DBRs. Term: 3 months, May 31 to Aug 31, 2010 (92 days) Rate: .23%, actual / 360

Repurchase price:

If A defaults, B can sell DBRs to recover the amount due.

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Repurchase Agreement: Unwind

Uses

Uses: Cash Management

Repo investor acts as counterparty B in figures. Relative to super-safe and liquid non-interestbearing deposits, repo
pays a short-term rate; sacrifices liquidity to chosen term, often o/n or open; high-quality collateral, haircuts, and daily margin calls protect loan in the event of a default. Example:
B lends only 106mm against the 111.772 bunds. If bund drops to 110mm, A has to put up another 1.772 of collateral.

Uses: Cash Management, cont.

Major Investors
Money Market Mutual Funds Municipalities

Other Investors
Other Mutual Funds; Insurance Companies; Pension Funds; Nonfinancial Corporations

Investors may specify categories, but accept GC. During the crisis, investors realized they were unprepared to seize and liquidate collateral.
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Uses: Long Financing

Financing Inventory to Facilitate Customer Flow
Client sells 100mm of the DBR to a trading desk. Desk needs to raise money to pay the client. Rather than draw on scarce capital (apart from haircut), the desk finances the purchase. Trading desk acts as counterparty A in the figures.

Until a buyer is found, desk has to roll the repo.

Rolling to a new funder is illustrated in Figure 12.3
If bund price falls or rises, there will be a shortfall or surplus after repaying B. Desk hedging should offset this shortfall or surplus.

Operations are complex.

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Rolling a Repo

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Uses: Long Financing, cont.

Financial firms are the typical cash borrowers.
Financing inventory to facilitate customer flow. Financing Proprietary Positions
Firm is again A in Figures 12.1 and 12.2.

Financing Customer Positions

Firm is A in Figure 12.3. B is a customer, typically a hedge fund C is an investor / funder.

Repo or Repo Out the Securities; Sell the Repo

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Reverses and Short Positions

Hedge fund shorts DBRs
Initiate the short
Sell bunds; need to borrow them to make delivery. Reverse in securities; buy the repo. Hedge fund is B in Figure 12.1.

Cover the short

Buy the bunds; deliver them to unwind reverse. Hedge fund is B in Figure 12.2. Use returned cash to pay for the bunds.

P&L 0 if bund return < repo rate; P&L 0 otherwise

Reverses require delivery of special collateral.

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Liquidity Management and the Financial Crisis

Liquidity Management
Source of funding
Most stable: equity capital Very stable: long-term debt Least stable: short-term unsecured debt, e.g., CP More stable sources are more expensive.

Firms balance stability and cost of funding through liquidity management. Repo funding is
relatively unstable because of its short term; more stable than unsecured funding.
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Liquidity Management, cont.

For broker-dealers and hedge funds, the loss of repo financing is often the killing blow. Repo funding of illiquid collateral closely tracks booms and busts. Regulators cannot simultaneously expect
financial institutions to lengthen the term of repo borrowing; lenders to shorten the term of repo lending.

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The Collapse of Bear Stearns

Testimony of Paul Friedman, May 5, 2010 Bear had financed itself with equity, secured, and unsecured funding. From year-ends 06 to 07, Bear
reduced short-term unsecured funding from $25.8b to $11.6b.
reduced CP from $20.7 to $3.9b.

replaced this funding with repo borrowing, and

substantially increased average term; obtained long-term facilities for whole loans and non-agency mortgages; limited short-term repo to Treasury or agency securities.
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The Collapse of Bear, cont.

From Aug 07 to early 08, repo lenders
shortened the term of loans; asked for higher quality collateral.

Week of 3/10/08, there was an unwarranted run on Bear that could not be survived:
PB clients withdrew cash and unencumbered securities; Repo lenders declined to roll over loans even on agency collateral; Counterparties to non-simultaneous FX trades refused to pay until Bear paid first.
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JPMs Exposure to Lehman

Bare-knuckle fighting over collateral in a default JPM was LBs tri-party repo clearing agent.
Repo investors lend literally overnight. Tri-party repo clearing agents lend intra-day to B/Ds on a secured basis. B/Ds cannot stay in business w/o this intraday credit. Before its final week, LB typically borrowed > $100b intraday from JPM. JPM did not take tri-party repo haircuts until early 08. JPM phased in haircuts for LB so as to match postings to overnight investors by Aug 08.
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LBHIs Lawsuit Against JPM

On the brink of LBHIs bankruptcy, JPM leveraged its life and death power as the brokerage firms primary clearing bank to force LBHI into a series of one-sided agreements and to siphon $billions in critically needed assets. The purpose of these last-minute maneuvers was to leapfrog JPM over other creditors by putting itself in the position of an overcollateralized creditor, not just for clearing obligations, but for any and all possible obligations of LBHI that JPM believed could result from an LBHI bankruptcy. The effect of JPMs actions taken with the benefit of unparalleled inside knowledge-- was devastating

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LBHIs Lawsuit Against JPM, cont.

JPM not only took $billions more than it needed from LBHI, but it also accelerated LBHIs freefall into bankruptcy by denying it an opportunity for a more orderly wind-down, costing the LBHI estate tens of $billions in lost value JPM drained LBHI of cash by repeated demands for increased collateral.
In the last 4 days, JPM seized $8.6 billion of collateral, including over $5 billion on the last day. JPM knew at the time it was already overcollaterized.

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JPMs Risks: Barry Zubrow

Increasing margin requirements to levels of overnight investors did not fully protect JPM:
taking all of a B/D book means great liquidation risks; no assurance that investors would roll funding; increasing amounts of structured, difficult-to-value securities were being financed through tri-party repo.

By late Aug and early Sep 08:

LBs deteriorating financing condition was apparent; It came to light that LB pledged many illiquid, structured securities with overstated values; JPM continued business as usual with LB anyway.
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JPMs Risks: Barry Zubrow, cont.

JPMs exposure to LB was growing, including areas unrelated to repo.
JPM asked LB for $5b in additional collateral.
JPM felt it could continue to face LB with this amount; JPM felt that LB could make this call; LBs executives did not say this created undue stress.

During the second week of Sep 08:

A review of LB collateral on Sep 11 indicated that large pieces were
Illiquid; could not be reasonably valued; were supported by LBs own credit.
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JPMs Risks: Barry Zubrow, cont.

During the second week of Sep 08, cont.:
JPM asked for another $5b of collateral.
This would still leave JPM at risk; JPM believed that LB could handle this amount; JPM would not extend credit the next day without payment.

LB delivered $5b on Sep 12.

Throughout all of this JPM continued to make enormous discretionary extensions of credit and continued to trade with LB

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Barclays, JPM, and the Fed

Deal of the Century, by Tom Junod Monday 15 Sep 08
Fed wants to keep LB B/D out of bankruptcy so trades can clear. Fed starts advancing the B/D $45b a day.

Tuesday 16 Sep
Barclays agrees to buy LBs NY building and specific assets; takes over U.S. operations.

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Barclays, JPM, and the Fed, cont.

Wednesday 17 Sep
Fed asks Barclays to take over its financing of the B/D by COB Thursday. Barclays agrees; Feds collateral is the good stuff. Barclays makes an overnight $15.8b loan to LB. JPM wants Barclays to take over some of its financing of LB as well
Barclays does not want to do this. The collateral JPM held was the bad stuff. JPM thinks Barclays has agreed to take over the $15.8b loan.

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Barclays, JPM, and the Fed, cont.

Thursday 18 Sep
Barclays to wire $45b to LB and get $49.7b in assets. Procedure is to send money and then receive collateral with JPM in the middle. Plans is to wire $5b at a time, starting early Thurs.
First batch, $5.06b in collateral, received 6 hours later. Barclays is rejecting collateral as it comes as bad stuff. Bill Winters call Bob Diamond: lets do all $40b; agreed. 6:55pm: Barclays wires $40b, expecting $49.7b of collateral. Barclays gets only $42.7b in collateral.

Barclays does not renew the $15.8b loan

Someone at Barclays says loan will be renewed.
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Barclays, JPM, and the Fed, cont.

Friday 19 Sep
1am: JPM puts $7b in Barclays account. Morning:
Barclays will not renew the $15.8b loan; Barclays $7b is frozen; JPM wants Barclays to take certain bad stuff and renew the $15.8b loan.

Fed forces a settlement:

Barclays gets $1.3b in cash and $5.7b good stuff.

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General Collateral (GC) and Special Repo Rates

General Collateral (GC)

The lender of cash is willing to accept any particular bond falling within broad parameters.
There is a GC rate for each collateral bucket and each repo term. The GC rate is for overnight Treasury collateral. In the U.S., GC is typically slightly below Fed Funds, but the spread depends on the supply and demand for collateral.
Late 90s early 00s, Treasuries scarcer as government pays down debt. Supply falls relative to demand in times of financial stress.

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Special Collateral
The lender of cash initiates the repo to take possession of a particular bond.
There is a special rate for every security and term. Special rates<GC to induce loans of particular bonds. Special spread: GC special rate of the same term. Supply and demand for a security as collateral differs from supply and demand to own that security. The determination of special rates varies by country.
In the U.S., the auction cycle is the most important determinant. In Germany, deliverability into futures is the most important.

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Specials and the Auction Cycle

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OTR 10-Year Special Spreads, I

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OTR 10-Year Special Spreads, II

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OTR 10-Year Special Spreads, III

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OTR 10-Year and the Auction Cycle

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Term Structure of Special Spreads

Forward spread from June 30 to July 28:

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Fails
Prior to May 1, 2009
Short the OTR 10-year and fail to deliver:
Do not receive cash from settlement Lose one day of interest on that cash.

Short the OTR 10-year and borrow it at 0%:

Receive cash from settlement. Lend cash at 0%.

Failing is the same as borrowing the bond at 0%.

Dont borrow if the special rate is less than 0%. Dont borrow if the special spread is greater than GC. The special spread is capped at GC.

After May 1: Penalty = max(3%-Fed Funds,0)

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Specials and the Level of Rates

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