We have had a lot of clients ask about repo and repo rates. This note is an attempt to explain the basics of the repo market and perhaps offer some insights as to what the repo rate volatility is suggesting.

We do believe that the Fed is on top of this and is providing ample liquidity to financial institutions to fund themselves. We do not necessarily think that repo rates will skyrocket, and the world will come to an end.

We do believe, however, that primary dealers and banks (financial institutions) are heavily levered and will continue to be heavily levered as the US Govt racks up larger and larger deficits and Corporations and Municipalities continue to issue more debt. As liquidity providers, these financial institutions hold some of this debt on their balance sheet until it is distributed to end buyers and they use the repo market to finance these positions.

Our concern is that these financial institutions are in a weak position to handle rate volatility, especially higher rates.  More repo volatility and negative headlines could result in outflows out of MMKT Funds. MMKT Funds can initiate gates and even charge liquidity fees. If this is a concern, we would suggest that clients limit their exposure to co-mingled funds (ie mmkt funds).

What is Repo?

Repo is another term for Repurchase Agreement.  In simple terms, a repo is a collateralized loan. The lender exchanges cash for a like amount of collateral. In most cases, the collateral is Treasury or Agency securities but can also be Mortgage and Corporate securities.

As an example, Counterparty A (lender) may lend 10 mlln of cash to Counterparty B (borrower). In exchange for the cash, Counterparty B puts up 10 mlln worth of collateral to secure the loan. Counterparty B agrees to pay Counterparty A interest (repo rate) for the borrow period. At the end of the borrow period, Counterparty B pays the principal and interest back to Counterparty A and Counterparty A returns the collateral to Counterparty B.

Why is Repo needed?

Most Banks, Primary Dealers, and levered Funds own large amounts of Fixed Income securities; far more than they can afford to pay for in cash. They need to borrow to pay for these securities. They rely on the repo market to borrow money at very low interest rates. In fact, a primary revenue source for many of these institutions is to borrow money at a low rate and lend it at a higher rate; for their bond positions, this is called positive carry. Negative carry occurs when repo rates rise or the curve inverts.

Corporations and Individuals often have excess cash that they need to lend/invest for short periods of time. The repo market provides opportunities for them to make secure loans. Corporations and Individuals often put their excess cash into MMKT Funds. Most of these Funds are very active in the repo market.

How are Repo rates set?

Repo rates are set by the supply and demand for money. When demand is more than supply then rates go higher and vice versa. Since Banks can borrow from one another at the Fed Funds rate, repo rates tend to gravitate to this level.

Risks of Repo?

If the borrower cannot repay the principal and interest, they are in default, and the lender can sell the collateral (securities) to recover the principal and interest owed. If the collateral is worth less than the principal and interest, then the lender must try to recoup any shortfalls in bankruptcy proceedings.

Why are repo rates high?

Banks, Primary Dealers, and levered mortgage Funds hold large amounts of bonds and need to borrow to pay for them.  As the US Government, Corporations, Municipalities, and Households issue more debt, the primary dealers will likely have to hold more debt on their balance sheet and will need the repo market to fund them.

The charts below display how many securities are held on Primary Dealer balance sheets as complied by the NY Fed. Issuance from all sectors will pick up in the fourth quarter (especially with lower rates) and these balance sheets will likely balloon further.

Traditional lenders currently have little excess cash to lend primarily because of quarterly tax payments and business needs surrounding trade and oil volatility.

In short, the demand for money far exceeds the supply.

What is the Fed doing?

The Fed has been conducting overnight repos. In our supply demand model, they are providing more supply by lending money to Banks and Primary Dealers in exchange for collateral (repos).

Starting last Tuesday 9/17/2019, the Fed has lent the following:

Tuesday = 53 blln

Wednesday = 75 blln

Thursday = 75 blln

Friday = 75 blln

Monday = 65 blln

Should we be concerned?

Repo rates very rarely spike as high as they did this past week and it implies that Financial Institutions are heavily levered and lenders particularly stingy about lending. All this during a time when market volatility is increasing. Given their large balance sheets, financial institutions may be more vulnerable to market volatility. Our concern is that even the perception of a valuation/credit problem could limit their access to the repo market as lenders will naturally gravitate to those counterparties that are more secure. The Fed will likely ensure that these institutions have access to repo, be we are uncertain what MMKT investors will do regarding more negative headlines about the repo market.

Should you be concerned about MMKT Fund exposure?

We do believe the Fed will provide ample liquidity to the Repo markets and become the lender of last resort. However, we do have some concern that we are starting a self-fulfilling process where negative headlines spook lenders, they lend less (in repo) and repo rates continue to be volatile, resulting in MMKT Fund outflows, more negative headlines, more outflows etc. If too many MMKT participants want out at the same time, then MMKT Funds may have to implement gates and/or liquidity fees.  We don’t believe this to be a base case scenario but we do recommend that clients limit their exposure to co-mingled funds until the liquidity issues subside.

Governor Rosello’s most recent Fiscal Plan continues to suggest that the Commonwealth (CW) has unsustainable amounts of debt, outdated infrastructure, and a fleeing population. Why then are Sr Cofina Bonds up 52% for the year and Jr Cofina bonds up 140%?

Implicit in the new Plan are subtle but significant changes. First, the CW is no longer viewing their debt holistically. For example, the PREPA (Electric Authority) and PRASA (Water Authority) budgets are no longer included in the General Fund budget. Their debt is now segregated, and each authority is required to have its own Fiscal Plan (budget). The objective, of course, is to privatize these and other authorities.  Without authority debt, the General Fund is left to support approximately 18 billion of General Obligation debt and 17 billion of COFINA debt as opposed to the 70 billion often quoted in media publications. 

Second, the projected budget surplus is growing. The plan now assumes a 6-billion-dollar surplus over six years (excluding debt service). This surplus assumes that the US Federal Government will decrease Puerto Rico’s Medicaid funding starting in 2020. If we assume the Feds continue to fund PR’s Medicaid needs at current rates, the surplus grows to 12 billion. Keep in mind that GO debt service is 9.5 billion and COFINA debt service is 5 billion over the same period; 12 billion surplus versus 14.5 billion in debt service. The Fiscal Board and the CW continue to press for significant debt restructuring, but their surplus projections don’t justify it.

The State of Connecticut has approximately 3.5 million people (similar to PR) and its annual debt service is 13% of revenues. If we assume that COFINA and Act 91 are legal, then the Fiscal Plan projects 11 billion of annual revenues. Annual GO debt service is approximately 1.5 billion dollars or 13.6% of revenues which is not far from that of CT. A 25% haircut to the GO debt reduces this ratio to less than 10%. The GO debt is now trading at 41.

Finally, Sales and Use Tax collections continue to be paid to the COFINA bond trustee. Bank of New York now holds close to 1.4 billion dollars in trust. We continue to believe that Judge Swain will determine COFINA to be legal and that this entity is the best structure/Issuer to access the capital markets going forward.

Congressman Bishop recently wrote a letter to the Fiscal Board scolding them for their general lack of regard for creditor rights which has impeded restructuring negotiations and prohibited Puerto Rico from moving forward.  Not by coincidence, this letter arrived shortly after the PR Governor refused to incorporate the Fiscal Board’s austerity measures in the revised Fiscal Plan due 4/30. Unfortunately, the Governor’s inability to implement these austerity measures will only delay the passage of a Fiscal Plan , create ill will, and delay/reduce needed recovery aid and investment.