Repo Fee

The Treasury reports that as of Friday, a new fee will be levied on participants in the Repo market of 3%. This is an interesting development; it's pretty unusual for the government to place any kind of punitive fee on any financial market. Why are they doing it?

A "repo" or "sale and repurchase agreement" is a kind of fixed rate short-term lending that uses debt or equity as collateral. A common form of debt to use is US Treasury debt.

An example of a repo transaction would go like this. Say I'm a bank with $10 mil in Treasury debt, and say I'd like to make an investment, but I also want to keep the Treasuries on my balance sheet. I can use a repo to sell the Treasuries to another bank, agreeing to repurchase the Treasuries some time later, for a set amount. Let's say I agree to repurchase the debt 100 days later for $10,0136,986.30. (This would imply that the yearly rate is 5%) I pay $136,986.30 to the lender for giving up my illiquid Treasury debt but knowing I could buy it back later at a fixed price. Why would I do it? Perhaps I have an idea in mind for an investment which would have a higher yield, but I need money to do it, not Treasury debt. Why not simply sell the Treasuries in the bond market and buy them back later? If I did that, there would be no entry in my balance sheet, and say I need to keep the Treasuries on my balance sheet because they are my reserves, and I must keep a certain ratio of reserves to deposits.

Repos are in fact commonly used by banks to have their cake and eat it, too. Banks can lend their reserves at a proft (thereby reducing their reserve ratio, which banks always want to do) and they can keep the Treasuries on their books as if they own the Treasuries, when in fact the bank no longer owns the Treasuries (at least for the term of the repo). The implied interest rate on repos (called the "repo rate") is usually a bit below the federal funds rate, currently at zero.

The unusual thing that began to happen on a large scale during the credit crunch of the fall of 2008 is that many of the buyers of repos (the lenders) did not return the Treasury debt on time. In fact, the total of all the late repos added up to $5 tril (there's a good discussion on the Naked Capitalism blog). There's no real penalty for this, but one question we might ask is: why?

Are the lenders unable to come up with the Treasuries? What did they do with them? Could they have done a repo on the Treasuries they just bought?

The Treasury will place a fee of 3% on the late repos. Because rates are so low, this will probably push the repo rate into negative territory. (Hey, just what Greg Mankiw wanted!) So if the repo rate is negative 3%, the math on my $10 mil repo changes. I now buy back my $10 mil in Treasury debt for only$ 9,917,808.72. Wow, free money! I get to make my investment (hope that works out) and I get to make an easy profit of over $82 grand!

Will the negative repo rate spur banks to make more repos, and hence to make more loans? Perhaps that's the goal of this policy change. My guess is that there will be unforeseen consequences. Who will rush to take the money-losing side of the repo? If there is no counterparty, then the repo market could be diminished, which may have the effect of raising reserve ratios, further contracting the money supply. Most economists these days are against a contraction in the money supply during a recession, especially "The Great Recession".