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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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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.