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Current time:0:00Total duration:11:24

Video transcript

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 you I don't know I need $10,000 for a kidney transplant can you lend me the money I'm in desperate need so we would you need you need $10,000 and I have $10,000 I sure you know I'm willing to lend to you but you know it's a tough economy and you never know where that money's gonna go and I don't know if you're gonna give me able to keep your job after you know going through this kidney surgery and all that so I've you know 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 you know that watch you have on your wrist that looks pretty nice you say this watch let me draw the watch this watch and I say yeah that watch like oh well you know this watch I got from my great-great grandfather and it's it's actually worth I don't know maybe it's a diamond studded Rolex of some sort and it's actually worth thirty thousand dollars right and I know that clearly because I've already become well acquainted with gold and diamonds and things like that so I say you know what I trust you and you trust yourself I'll give you the ten thousand I'll lend you the ten thousand dollars 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 if you when you pay back the $10,000 with a low interest let's say it's I don't know 10% a week 10 / 10 percent per week when you pay back the the money the principle with the interest however long you borrow it I'll give you back your watch and you're like oh I don't know about that you know first of all 10% the week sounds a lot I was like whoa well don't you just need it for the kidney transplant tomorrow and then you could work a couple of weeks and then pay it back 10% a weeks not bad and we all know that that is because you compound that over the year and it becomes some type of a 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 gonna get your $30,000 watch back so what's there to worry all 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 a 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 unless less shady parts of her economy a bank will give you a loan and they'll collateralize it buy 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 paid back I give you back the collateral now what if there was a reality where I don't even you know me as the lender I don't even like this notion of collateral and all of that I actually want to make it you know very clear that I have ownership of the collateral when it happens right I don't want you know some feds coming in and saying wow you know whose watch that is this that you're holding you know where's the receipt for this where did you get it was it stolen from somebody and you know it looks all shady and I probably do have some sighs shy sides 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 and this is me again I I'll draw that at least the top hat in the mustache those are my differentiating characteristics and 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 I'll buy the watch from you for a ten thousand dollars and I get the watch you get the money but we'll also have a side agreement well so so far it's almost identical right the only difference mean this what we did before I'm actually selling the money I'll actually selling the watch to you 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 what add-on to this is an agreement that at some future date your guy said this is now this is now we're also going to have an agreement and both of us are parties to this and the that in the future in the future I will agree to sell and you will agree to buy this watch from 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 plus something and that something is essentially interest right so I'll let 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 I have completely 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 to I 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 you will repurchase this as the watch right here you will repurchase the 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 we have a repurchase agreement repurchase agreement where you agree to repurchase the watch at some point and it's actually I'm the holder of the repurchase agreement so the money lender the 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 a reverse repo but the whole idea here is this Agreement forces you to buy to buy the watch back at some at the original amount that you essentially borrowed from me plus some interest and this reverse recension forces me to sell it to you so we have a pre 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 transact this is how the Fed lends especially with the discount window so let me 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's say 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 liability some equities let's say it has a ton of assets has a ton of assets that say that these are 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 Fed we're the Federal Reserve let me see if I can draw their balance sheet properly and the Federal Reserve it can well for the most part this these are going to be you know Treasuries right now it has some liabilities I won't go into that just yet it has some equity and if it's going to land 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 this is the Fed Reserve you go to the Federal Reserve discount window the discount rate might be I don't know five percent 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 okay let me print some money for you so these are the liabilities notes outstanding and they print 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 are is that the Federal Reserve will buy these Treasuries from you so now all of a sudden the Treasuries let me see if I can do it so if I copy and paste so actually let me copy and paste this C V so the Federal Reserve notes will go from from the from does the the Federal Reserve to you and then your cash will go to the and 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 behind that we're 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 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 reverse not a reverse that's what differentiates a repo agreement from a 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 a lot of time in the next video we'll actually look at the Federal Reserve's balance sheet