Fortune Magazine: Why the Repo Market Is Such a Big Deal, and Why Its $400 Billion Bailout Is So Unnerving

Article by Alexander Saeedy in Fortune

One of the most vital pieces of plumbing that powers the global financial system usually runs so smoothly that it gets overlooked by market watchers. It’s the “repo market,” comprising the short-term funding that banks and financial counter-parties regularly tap to lend each other trillions.

It’s suddenly in the news again, and for all the wrong reasons. The repo market is looking a lot like it did on the precipice of the 2007 housing market crash.

But what is the repo market, anyway, and why has the Federal Reserve Bank this week injected hundreds of billions of dollars into the financial system to stabilize it?

A $1 Trillion Market Springs a Leak

Large corporations and banks typically hold vast quantities of highly liquid financial assets, and so they like using these markets as a means of quick and easy financing. In fact, there are more than $1 trillion worth of overnight repo transactions collateralized with US government debt occurring every day. Banks frequently go to these markets to fund the loans they issue, and to finance the trades they execute.

That’s when it’s working smoothly.

The repo market seized up last week, with median repurchase rates skyrocketing from their usual band of 2.00-2.25% to 2.46% on Monday, and 5.25% on Tuesday. Keep in mind, that’s the median rate. Some repo rates were as high as 9%, more than quadruple the Federal Reserve’s own target rate, which usually puts a cap on how high Treasury repo rates could climb.

What happened last week was any counter-party in need of cash, and only holding collateral like Treasuries, agreed to pay the much higher going repo rates. That’s supply and demand, plain and simple, and it mirrors what happened in certain repo markets in 2007 before the housing crash and the Great Recession that followed.

“For all intents and purposes, this will be equivalent to QE, with scheduled purchases of securities. We estimate that over the first year, the Fed would need to buy roughly $400bn of Treasury securities to achieve an appropriate level of reserves, plus a buffer,” the Bank of America wrote in a research note.

As plumbing problems go, this will be an expensive one to sort out.

To read this critical article in Fortune in its entirety, click here.