Near the end of the third quarter, the overnight funding market (commonly referred to as the “repo market”) exhibited a level of instability not seen since the financial crisis. However, many individuals don’t fully understand the implications of this disruption, nor do they have a full grasp of what the repo market even is.
So, what is the repo market exactly?
In simple terms, it refers to where banks and other financial institutions go to borrow funds on a very short-term basis (hence the term “overnight”). Given the complexity of financial institutions and the sheer volume of transactions they execute, these institutions often have short-term liquidity shortages. As a result, they go to the repo market to borrow cash from an institution that has excess liquidity. The borrower typically sells investment-grade securities to another institution and agrees to repurchase (i.e. repo) these securities the next business day at a slightly higher price (the implied interest rate). Thus, the borrower obtains the cash needed for an overnight funding gap and the lender earns a tiny profit on excess funds that is nearly riskless given the short duration of the loan and the nature of the securities.
Why should investors care about this market?
The repo market is the “lifeblood” of the financial industry. Without it, many banks and financial institutions would not be able to efficiently execute transactions and fulfill obligations over time. If the repo market experiences significant stress, it will have major ramifications on the economy due to a reduction in banking activity along with eroding investor confidence in the financial system. During the most recent financial crisis, financial institutions lost confidence in the mortgage and asset-backed securities that were being sold and repurchased in the repo market as cracks became evident in the housing market. As a result, the repo market froze, which intensified the banking crisis that ensued as faith was lost in the financial system.
So, what drove the disruption in this market during the third quarter?
In summary, approximately $150 billion in corporate tax payments came due at the same time as U.S. Treasuries were being auctioned. Consequently, there was an outflow of bank deposits from the private sector to (1.) fulfill tax obligations and (2.) purchase Treasuries that were being auctioned (potentially also exacerbated by withdrawals by depositors making payments for quarterly individual tax estimates). As bank deposits/reserves were depleted, the cost of funding in the repo market spiked above Fed funds on multiple occasions to as high as 9% due to the reduction of liquidity in the system. In response, the Federal Reserve is intervening in the repo market by offering a daily borrowing line which has reduced the cost of borrowing toward the desired range of Fed funds.
What is the state of the repo market today?
In the short term, the Fed has stabilized the market and this incident is being viewed as a simple “glitch.” However, we believe there is elevated risk of additional liquidity shortages going forward. One driver being the implementation of Dodd-Frank and Basel III bank regulations. These regulations force banks to hold large amounts of liquid assets and de-emphasize growth, causing banks to reduce lending activities. This exacerbated the recent liquidity crunch as large banks did not (or could not) lend money overnight despite advantageous rates. Another risk factor is cash is in short supply since the Fed began quantitative tightening - shrinking its balance sheet by nearly 40% since 2017. As the Fed reduced its balance sheet, it also reduced the amount of cash in the banking system. Less cash in the banking system equates to a greater chance of overnight liquidity shortages.
The recent hiccup in the repo market is, at a minimum, a reminder that regulators don’t always achieve the proper balance the first time through a set of adjustments. The episode was certainly a sign of stress in the system, brought on by a squeeze on both ends of the overnight financing supply/demand balance – and a potential canary in the coal mine.
We at Prospector Partners have long favored banks and financial institutions which:
- Hold significant excess capital and liquidity
- Have simple and “vanilla” balance sheets
- Are less dependent on overnight borrowings
- Are small enough to be exempt from onerous regulatory requirements
- Do not have complex repo market trading operations
While not immune, we expect our holdings to be more resilient to potential stress in the money markets. That said, we are hopeful this liquidity issue will eventually abate. The Federal Reserve will let its balance sheet expand over time which will inject cash into the system, thereby improving liquidity. Furthermore, there is momentum from the Federal Reserve and OCC behind scrapping a bank margin requirement rule which would free up $40 billion in capital for lending activities among other proposed reforms.