Trading and Capital-Markets Activities Manual
Profiles: Repurchase Agreements
A repurchase agreement (repo) involves the sale of a security to a counterparty with an agreement to repurchase it at a fixed price on an established future date. At initiation of the transaction, the buyer pays the principal amount to the seller, and the security is transferred to the possession of the buyer. At expiration of the repo, the principal amount is returned to the initial buyer (or lender) and possession of the security reverts to the initial seller (or borrower). Importantly, the security serves as collateral against the obligation of the borrower and does not actually become the property of the lender. Given the short tenor of a typical repo and the need to make proper custody arrangements for the securities involved, operational issues are important to proper management of repo activities. At times, in addition to being a counterparty in some transactions, a bank may serve as third-party custodian of securities collateral in other transactions as a service to the buyer and the seller.
In a repurchase agreement, a bank borrows funds when it ''sells'' the security and commits to ''repurchase'' it in the future. In a reverse repurchase agreement, the bank lends funds when it ''buys'' the security and commits to ''resell'' it in the future. A reverse repo is sometimes termed a resale agreement or a security purchased under agreement to resell (SPAR). The terms ''repo'' and ''reverse repo'' thus describe the same transaction, but from the perspective of each counterparty.
A closely related instrument is a dollar roll, which is identical to a repurchase agreement except that the ''repurchase'' leg of the transaction may involve a similar security rather than the specific security initially ''sold.'' In a dollar roll, the transaction contract explicitly allows for substitution of the collateral. The borrower of funds in this transaction thus runs the risk that at the closing of the transaction he or she will own a security that is generally comparable but inferior in some material way to the original security.
CHARACTERISTICS AND FEATURES
Most repos are conducted with U.S. Treasury or agency securities as collateral. Repos of mortgage pass-through securities and collateralized mortgage obligations (CMOs) issued or guaranteed by U.S. government agencies are less common but occur frequently. Repos of other securities or loans are not common, in part because the Federal Reserve System generally considers repos with other assets to be deposits of the selling institution and subject to Regulation D reserve requirements.
Repos can be conducted on an overnight basis, for a longer fixed term, or on an open account basis. Overnight repos, or one-day transactions, represent approximately 80 percent of all repo transactions. Anything longer (called a ''term repo'') usually extends for less than 30 days. Repo agreements ''to maturity'' are those that mature on the same day as the underlying securities. ''Open'' repo agreements have no specific maturity, so either party has the right to close the transaction at any time.
In general, repos are attractive to a variety of market participants as (1) a low-cost source of short-term funding for borrowers and (2) an asset with high credit quality regardless of the counterparty for suppliers of funds. Participation in this market requires proper operational and administrative arrangements as well as an inventory of eligible collateral.
Repos can be used to finance long positions in dealers' portfolios by short-term borrowing. The repo market is a highly liquid and efficient market for funding dealers' bond inventory at a short-term rate of interest. Dealers may also use repos to speculate on future levels of interest rates. The difference between the coupon rate on the dealer's bond and the repo rate paid by the dealer is called ''carry,'' and it can be a source of dealer profit. Sometimes the borrowing rate will be below the bond's coupon rate (positive carry), and sometimes the borrowing rate will be above the bond's coupon rate (negative carry).
Dealers may use reverse repos to cover short positions or failed transactions. The advantage of the reverse repo is that a dealer may borrow a security it has sold short with either positive or negative carry. A problem arises, however, when demand exceeds supply for a specific bond issue (collateral), and it goes on ''special.'' This means that those who own the security can earn a premium by lending it to those needing to deliver on short positions. These ''lenders'' are compensated by paying a below-market borrowing rate on the cash side of the transaction (the repo rate is lower on ''specials'' because the owner of the special security is the borrower of cash funds and is seeking the lowest lending rate possible).
Bank Non-dealer Activity
Like dealers, a bank can use repos to fund long positions and profit from the carry. The market also gives a bank the means to use its securities portfolio to obtain additional liquidity-that is, funding-without liquidating its investments or recognizing a gain or loss on the transaction. For money market participants with excess funds to invest in the short term, reverse repos provide a collateralized lending vehicle offering a better yield than comparable time deposit instruments.
Repos have proved to be popular temporary investment vehicles for individuals, firms, and governments with unpredictable cash flows. Repos (like other money market instruments) can also be used as a destination investment for commercial depositors with sweep accounts, that is, transaction accounts in which excess balances are ''swept'' into higher-yielding non-bank instruments overnight. Again, as collateral for the corporation's investment, the counterparty or bank will ''sell'' Treasury bills to the customer (that is, collateralize the loan).
DESCRIPTION OF MARKETPLACE
On any given day, the volume of repo transactions amounts to an estimated $1 trillion. Important lenders of funds in the market include large corporations (for example, General Motors) and mutual funds. Borrowers generally include large money-center or regional banks with a need for funding.
Repos are not traded on organized exchanges. There is no secondary market, and quoted market values are not available. The Public Securities Association has produced a standard master repo agreement and supplements that are used throughout the industry. Although the transactions themselves are not rated, the entities undertaking repos (such as larger banks and dealers) may be rated by Moody's, Standard & Poor's, or other rating agencies.
PRICING Repo rates may vary somewhat with the type of collateral and the term of the transaction. Overnight repos with U.S. government collateral, however, generally take place at rates slightly below the federal funds rate. Interest may be paid explicitly, so that the ''sale'' price and ''repurchase'' price of the security are the same, or it may be embedded in a difference between the sale price and repurchase price.
The seller of a security under a repo agreement continues to receive all interest and principal payments on the security while the purchaser receives a fixed rate of interest on a short-term investment. In this respect, interest rates on overnight repo agreements usually are lower than the federal funds rate by as much as 25 basis points. The additional security provided by the loan collateral employed with repos lessens their risk relative to federal funds.
Interest is calculated on an actual/360 day count add-on basis. When executed under a continuing contract (known as a demand or open-basis overnight repo), repo contracts usually contain a clause to adjust the interest rate on a day-to-day basis.
Since repo rates move closely with those of other short-term instruments, the hedge vehicles available for these other instruments offer an attractive hedge for positions in repos. If the portfolio of repos is not maintained as a matched book by the institution, the dealer or bank could be subject to a level of residual market risk.
Repos and reverse repos, if used to fund longer or more sensitive positions, expose the institution to changes in the future levels of interest rates.
The buyer is exposed to the risk that the seller will default on his or her obligation to repurchase the security when agreed. Of course, the buyer has access to the security as collateral and, in the event of default, the security could be sold to satisfy the debt. However, this could occur only through legal procedures and bankruptcy. Despite the conventional terminology, this type of transaction is a collateralized advance and not truly considered a sale and repurchase. If the value of the security has declined since the funds were disbursed, a loss may be incurred. Over collateralization and margin arrangements are used to reduce this risk.
If the buyer is to rely on its ability to sell a security in the open market upon the seller's default, it must exercise effective control over the securities collateralizing the transactions. The Government Securities Act was passed in 1986 to address abuses that had resulted in customer losses when the security was held by the seller. Its requirements include that (1) written repurchase agreements must be in place, (2) the risks of the transactions must be disclosed to the customer, (3) specific repurchase securities must be allocated to and segregated for the customer, and (4) confirmations must be made and provided to the customer by the end of the day on which a transaction is initiated and on any day on which a substitution of securities occurs. Participants in repo transactions now will often require securities to be delivered or held by a third-party custodian. (See section 2020.1 of the Commercial Bank Examination Manual.)
The accounting treatment for repurchase agreements is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 125, which has been replaced by SFAS 140, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' (Both statements have the same title.) Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING
In general, assets collateralized by the current market value of securities issued or guaranteed by the U.S. government, its agencies, or government-sponsored agencies are given a 20 percent risk weight. If appropriate procedures to perfect a lien in the collateral are not taken, the asset should be assigned a 100 percent risk weight. For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.''
LEGAL LIMITATIONS FOR BANK INVESTMENT
Repos on securities that are eligible for bank investment under 12 USC 24(7th) and 12 CFR 1, and that meet guidelines set forth by the Federal Reserve System, may be held without limit. Repos that do not meet these guidelines should be treated as unsecured loans to the counterparty subject to 12 USC 84, and combined with other credit extensions to that counterparty. Repos with affiliates are subject to 12 USC 371c.
Board of Governors of the Federal Reserve
System. Commercial Bank Examination Manual. Section 2030.1, ''Bank Dealer
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