Repurchase Agreements (Repo transactions) Mechanics of repurchase agreements (repo transactions/loans)
Repurchase Agreements (Repo transactions)
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- Let's say that you're in desperate need of money and I
- have money to lend to other people.
- So this is me and this is my gold chain.
- So you come to me and say, Sal, I need $10,000 for a
- kidney transplant.
- Can you lend me the money?
- I'm in desperate need.
- And I have $10,000.
- Sure, I'm willing to lend it to you, but it's a tough
- economy and you never know where that money's going to go
- and I don't know if you're going to be able to keep your
- job after going through this kidney surgery and all that.
- So I'm very careful with my money so I want to make sure
- that you're good for it.
- So we think about it a little bit and I say, hey, that watch
- you have on your wrist, that looks pretty nice.
- You say, this watch?
- Let me draw the watch.
- And I say, yeah, that watch.
- You're like, this watch I got from my
- great-great-grandfather and it's actually worth-- I don't
- know-- maybe it's a diamond studded Rolex of some sort and
- it's actually worth $30,000, right?
- And I know that, clearly because I've already become
- well acquainted with gold and diamonds and things like that.
- So I say, I trust you and you trust yourself.
- I'll lend you the $10,000, but just so that we all know that
- everything's going to be fine, why don't you just leave your
- great-grandfather's watch with me?
- And when you pay back the $10,000 with a low interest--
- let's say it's 10% a week-- when you pay back the money,
- the principal, with the interest, however long you
- borrow it, I'll give you back your watch.
- You're like, I don't know about that.
- First of all, 10% a week sounds like a lot.
- I was like, well, don't you just need it for the kidney
- transplant tomorrow and then you can work a couple of weeks
- and then pay it back.
- 10% a week's not bad-- and we all know that that is because
- you compound that over the year and it becomes some type
- of horrendous interest rate.
- But you're desperate.
- You need your kidney and I'm like, look, you plan on paying
- me back, right?
- So you're going to get your $30,000 watch back, so what's
- there to worry, right?
- So why don't you just leave this with me as collateral?
- And you say, fine and you leave your watch and you get
- your kidney transplant and then you try to work really
- hard to pay it back, but you never can
- and I keep your watch.
- And this is how the pawn process essentially works.
- You've pawned your watch off to me, but in a less kind of
- derisive way of talking about it, you've given it as
- collateral for a loan.
- And I was willing to give you the loan because I knew that
- if you couldn't pay it back, I could keep this nice asset.
- And this happens all the time in less shady
- parts of our economy.
- A bank will give you a loan and they'll collateralize it
- by the house.
- If you can't pay the loan, they keep the house.
- They want you to put a down payment on the house so that
- even if the house devalues, they still capture back most
- of their money.
- And so this is a pretty straightforward
- collateralized loan.
- This is the collateral you give me.
- I give you the loan.
- You pay it back.
- I give you back the collateral.
- Now what if there was a reality where I don't-- me as
- the lender, I don't even like this notion of collateral and
- all of that.
- I actually want to make it very clear that I have
- ownership of the collateral when it happens, right?
- I don't want some Feds coming in and saying, wow, whose
- watch is this that you're holding?
- Where's the receipt for this?
- Where did you get it?
- Was it stolen from somebody?
- And it looks all shady and I probably do have some side
- shady operations anyway so I want to know that I own this
- watch in the event that you don't come
- back to pay the loan.
- So instead, we could have done this exact same transaction--
- so this is you again.
- This is me again.
- I'll draw that top hat and the moustache.
- Those are my differentiating characteristics, maybe the
- gold chain.
- And now what I can do is-- because I want ownership of
- that watch, what I'll do is I will buy that watch from you.
- So you'll give the watch-- so the watch will literally
- change hands.
- So I will buy the watch from you for $10,000.
- But we'll also have a side agreement.
- So far it's almost identical, right?
- The only difference between this and what we did before
- is, I'm actually selling the money.
- I'm actually buying the watch from you.
- This is a cash transaction.
- This wasn't a loan, strictly speaking, but the same thing
- is happening, right?
- Up here you handed me the watch and
- I handed you $10,000.
- Here, you handed me the watch and I handed you $10,000.
- But what we'll add on to this is an agreement that at some
- future date-- so this is now.
- We also going to have an agreement-- and both of us are
- parties to this-- that in the future, I will agree to sell
- and you will agree to buy this watch for me for something
- more than $10,000.
- So in the future, you're going to give me back my money.
- So it'll be $10,000 plus something-- and that's
- something is essentially interest, right?
- So I'll get my money back and then I'll give
- you back the watch.
- So if you think about it, this is completely identical
- economically to what we did up here, right?
- I gave you $10,000.
- You gave me the watch as collateral.
- When you pay back the $10,000 plus interest, I give you back
- the watch, right?
- But at no time did I really have real, legitimate
- ownership of that watch.
- Well, in this situation, the same thing happens.
- You come to me.
- I give you money.
- You give me the watch, but I bought it from you so I have a
- receipt too.
- I am the official owner of the watch while you have my money,
- but we have an agreement that at some future date, you will
- repurchase the watch from me.
- for $10,000 plus some amount, which is essentially the
- interest. So this was a loan collateralized by a watch, but
- the only difference here is that instead of it just being
- collateral, you actually sold it to me and then we had a
- repurchase agreement-- and it took me six minutes to say
- that, but I think it was worth it-- where you agree to
- repurchase the watch at some point.
- It's actually I'm the holder of the repurchase agreement.
- So the money lender-- so I get the watch and
- a repurchase agreement.
- We'll call that a repo.
- So these are two assets that I now have-- the watch plus the
- repurchase agreement.
- You get the money.
- And it's actually called a reverse repo, from
- your point of view.
- But the whole idea here is this agreement forces you to
- buy the watch back at the original amount that you
- essentially borrowed from me plus some interest. And this
- essentially forces me to sell it to you.
- So we have a-- it's
- essentially a forward contract.
- A forward contract is just an agreement to transact in the
- future at some given price.
- And the whole reason why I did this is because this is how
- the Fed transacts.
- This is how the Fed lends, especially with
- the discount window.
- Sometimes it's called a repo transaction or
- a repurchase agreement.
- And so what the Fed does when someone comes to it at the
- discount window-- let me actually draw proper balance
- sheets now.
- Let's say that this over here is a bank in need.
- I won't worry about the right-hand side of the balance
- sheet too much.
- It has some liabilities, some equities.
- Let's say it has a ton of assets.
- Let's say that these right here are treasuries.
- But it's all out of cash, right?
- This is the bank.
- It's all out of cash and on the other hand, we have the
- Federal reserve.
- Let me see if I can draw their balance sheet properly.
- And the Federal reserve-- well, for the most part, these
- are going to be treasuries right now.
- It has some liabilities.
- I won't go into that just yet.
- It has some equity.
- And let's say you're one of these pariah banks.
- No-one's willing to lend to you.
- Your depositors are taking out their money.
- So you need to convert some of these treasuries into cash.
- You don't want to just dump them on the market.
- Maybe there are other assets that are less liquid and if
- you just dump them, you won't get the value you want.
- So essentially you enter into a repurchase agreement with
- the Federal reserve.
- So this is the Fed reserve.
- You go to the Federal reserve discount window.
- The discount rate might be-- I don't know-- 5% on an annual
- basis, but we won't get into the technicalities of that.
- You say, hey, Fed, lend me some money.
- And the Fed says, OK, let me print some money for you.
- So these are the liabilities notes outstanding and then he
- prints some Federal reserve notes, but instead of just
- lending the money to you and then keeping these treasuries
- as collateral, the Federal reserve will actually buy
- these-- it'll enter into a repurchase agreement with you.
- So the mechanics of that is that the Federal reserve will
- buy these treasuries from you.
- So now all of a sudden, the treasuries-- the Federal
- reserve notes will go from from the Federal reserve to
- you and then your cash will go to-- then your treasury notes
- will go to the Federal reserve, right?
- This is cash-- Federal reserve printed cash, gave it to you,
- and then essentially bought treasury notes from you.
- So now these are treasury notes.
- These are the treasury notes that were here before.
- But it has a repurchase agreement where you agree at
- some future date to unwind this transaction, where you're
- going to buy back your treasuries and you're going to
- pay the amount that the treasury paid you initially
- plus some interest, right?
- So the basic way to view it is, this was just a loan.
- You just borrowed this much from the Federal reserve.
- The Federal reserve kept your treasuries as collateral, but
- it actually had formal ownership over it.
- And that's what differentiates a repo agreement from just a
- traditional collateralized loan, but in the future you're
- going to buy back those treasuries for the amount the
- Federal reserve had originally bought them from you for plus
- a little bit of interest. You're going to pay a little
- interest and that interest is going to be dictated by the
- discount rate.
- Anyway, all out of time.
- In the next video, we'll actually look at the Federal
- reserve's balance sheet.
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