There's been a couple of news stories in the last week on
the repo market, relating to the potential impact of the bank leverage ratio,
and on a proposal for a Fed fixed rate reverse repo facility. The latter, in particular, is of particular
interest to those who have expressed concern over the impact of QE operations
on the pool of eligible collateral in the repo market.
The ability of certain investors to fund their positions
with repo has a significant impact on their desire to hold those positions. The size of the repo market therefore has an important
effect on the overall demand for investments and by implication for the market
value of securities. The consequences of
this should be clear, as a contraction in the repo market was one important
element in the financial crisis.
However, the relationship between the volume of repo finance
and the price of securities is a complex one.
A reduction in repo does not necessarily go hand in hand with a fall in
asset values - it depends what is driving it.
The balance sheet analysis that follows is intended to illustrate in a
fairly simple manner how this relationship could go either way.
The table below shows
an extract from the national balance sheet.
This involves four entities: leveraged funds (LF); banks (B),
unleveraged funds (UF) and the central bank (CB). Leveraged funds are taken here to represent
the sorts of entities (broker/dealers, hedge funds) that might typically fund
themselves with repo. The asset shown
are Treasuries, high grade mortgage-backed securities (MBS), repo, reverse repo
and deposits and reserves. Here, I am
taking repo and reverse repo to be from the bank's perspective. That means that a repo is where the bank has
effectively taken in a deposit against collateral and a reverse repo is where
the bank has effectively provided a loan against collateral.
LF
|
B
|
UF
|
CB
|
Total
|
|
Treasuries
|
50.00
|
200.00
|
250.00
|
||
MBS
|
50.00
|
200.00
|
250.00
|
||
Bank reverse repo
|
-80.00
|
80.00
|
0.00
|
||
Bank repo
|
-80.00
|
80.00
|
0.00
|
||
Deposits
|
-120.00
|
120.00
|
0.00
|
||
Reserves
|
I am assuming in the above that the leveraged fund has
repoed out all of its Treasuries and 30 of its MBS. The remaining 20 of the MBS are ineligible as
collateral. For simplicity, I have
ignored the haircuts - the additional collateral that has to be provided over
the amount of cash raised.
So, I now want to look at what might happen if the providers
of cash get concerned about the quality of the collateral. In particular, I want to see what happens if
they decide that they will no longer accept some of the MBS currently being
repoed. This is one element of what
happened in the financial crisis.
To do this, I need to make some assumptions about the
portfolio decisions of the leveraged and unleveraged funds. To make it really simple, I'm going to assume
that the unleveraged fund just maintains an equal investment (by value) in
Treasuries, MBS and monetary assets (repo plus deposits). I'm going to be a bit vague about the
investment criteria of the leveraged fund, in order to keep to round numbers,
but I'm going to say that the amount of Treasuries and MBS they wish to hold
depends on the price. The greater the
price, the lower the expected yield, so the less they wish to hold.
LF
|
B
|
UF
|
CB
|
Total
|
|
Treasuries
|
47.50
|
190.00
|
237.50
|
||
MBS
|
35.00
|
190.00
|
225.00
|
||
Bank reverse repo
|
-70.00
|
70.00
|
0.00
|
||
Bank repo
|
-70.00
|
70.00
|
0.00
|
||
Deposits
|
-120.00
|
120.00
|
0.00
|
||
Reserves
|
The table above shows the new equilibrium position. Various things have happened here. The trigger is an amount of repoed MBS
ceasing to be acceptable collateral. This
leads to part of the repo and reverse repo being repaid. The leveraged fund finances this by selling
the MBS it can no longer post. These are
purchased by the leveraged fund with the cash freed up from reduced repo.
These cash movements are accompanied by movements in the
market price of both MBS and Treasuries.
The attempt by the leveraged fund to offload the MBS it can no longer
post pushes down the price, enough to induce the unleveraged fund to buy. As the price falls, the unleveraged fund
attempts to rebalance its portfolio by selling Treasuries. This pushes down the price of the Treasuries
as well and the unleveraged fund increases its holding slightly. The fall in the price of Treasuries and MBS
can be seen by looking at the total value in the last column. Both prices fall, but that for MBS falls
further. (Note that we are assuming that this extract balance sheet represents a "closed" system. There are no sales or purchases with other investors not shown, nor any new issuance. As aggregate sales is zero, equilibrium can only be attained by price movements and the change in the value of holdings is entirely reflective of changes in price.)
So this scenario results in a decline in asset values, as
well as a reduction in bank lending and the broad money supply (reverse repo is
a form of bank lending and repo is included in the broad money measure).
The second scenario I wanted to look at was a central bank
purchase of Treasuries. The starting
point for this will be the same base case as before. The mere announcement of the purchase will
lead to an increase in the price of Treasuries due to the extra demand. The rise in price will induce the leveraged
fund to reduce its holding, selling Treasuries which the central bank ultimately
acquires. The sale proceeds are used to
reduce the reverse repo position.
LF
|
B
|
UF
|
CB
|
Total
|
|
Treasuries
|
45.75
|
203.00
|
10.00
|
258.75
|
|
MBS
|
49.50
|
203.00
|
252.50
|
||
Bank reverse repo
|
-73.00
|
73.00
|
0.00
|
||
Bank repo
|
-73.00
|
73.00
|
0.00
|
||
Deposits
|
-130.00
|
130.00
|
0.00
|
||
Reserves
|
10.00
|
-10.00
|
0.00
|
The unleveraged fund also sells Treasuries, prompted by the
rise in price. The unleveraged fund
simply aims to keep a balanced portfolio, so as the value of its Treasury
holdings rises, it must sell some in order to rebalance. It uses some of the sale proceeds to acquire
more MBS and some to build up its monetary assets. The increased demand for MBS pushes up the
price of those securities inducing the leveraged fund to sell. The final equilibrium is shown in the table
above.
The bank now holds a greater reserve balance, but this is
offset by greater deposits from the unleveraged fund. Overall monetary assets have risen, as has
the value of Treasuries, the value of MBS and overall net private sector
financial assets. Note that although the
overall value of Treasuries has risen, along with the price, the value of
private holdings of Treasuries has fallen.
One main purpose of this exercise was to highlight what has
happened to debt levels. Although broad
money (which includes repo) has increased as a result of the central bank asset
purchases, lending (including reverse repo) has fallen. This (reflux) effect might appear to be
contractionary in that we normally associate a fall in lending with a reduction
in demand. However, although the decline
in lending may itself be contractionary, it is actually just a partial response
to an expansionary measure. It reduces
the impact of the expansion, but it can never be so great as to negate it.
In terms of the real economy, this form of lending (i.e. for
asset purchase) can have no expansionary effect beyond its impact on the price
of assets. The test of whether the central bank asset
purchases have been expansionary is whether asset prices have increased, not
whether net lending has. How expansionary
an increase in asset prices is for the real economy is another matter.
