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So what exactly is a reverse repo and why should I care?

Ben Bernanke
Don’t panic! I’m an economist!

Last week, Ben Bernanke announced that the recession maybe just possibly could be there’s a chance cross your fingers might be over. Unless, he added, maybe just possibly could be there’s a chance the recession might not be over. Today, news leaked that the Fed is drawing up plans to hoover up some of the one trillion extra dollars it dam-burst into the economy since last September with a hefty pile of reverse repos or repurchase agreements.

Now, economic and business news is larded with news reports about fancy financial instruments, like CDO’s and credit swaps and repos, and reporters dutifully throw them out just to show you they know what they’re talking about when they really don’t. (kind of like literature scholars).

So, in the interest of putting this news in some context, I offer the slimmed down version of repos 101. Not for dummies, just for people who want to know without expending any effort.

This is how the Fed reverse repo program will work.

The Federal Reserve Bank plans to borrow money from banks, thus taking all that money out of the economy. Why? Because “Helicopter” Ben decided that the helicopter idea wasn’t such a bad one (when asked at a Congressional hearing last year about the prospects of a recession, Bernanke replied that the Fed could prevent a recession by “dumping money out of helicopters,” thus the sobriquet, “Helicopter” Ben.) It’s not like the Fed dumped money on the banks — they actually purchased assets (mostly “toxic” assets). A trillion dollars worth, in fact.

That’s good news in a recession. But bad news in a recovery since it could lead to inflation.

So as the economy picks up, the Fed needs to take some of that money back out of the economy or prices (and interest rates) will skyrocket. If they don’t, we’re out of the proverbial frying pan only to roast in the proverbial fire.

Keeping in mind my eternally true dictum that economists don’t know the answers much better than the rest of us don’t know the answers, most economists think that somewhere between $400 million and $600 million in the economy needs to go AWOL when the economy starts recovering or we’ll be in for a mighty rough ride.

But it’s not like the Fed can go to the banks it purchased assets from and say, “Give me my money back.”

They’ll have to borrow it.

You heard right. They have to borrow it back.

Normally, when you borrow money, you pledge collateral against it. Say you have $10,000 in Treasury bonds and you want to borrow $10,000. You can use the Treasury bonds as collateral, no? As long as you and your lender agree that you can’t sell those Treasuries, they make great collateral.

Better yet, you could effectively borrow the $10,000 dollars by selling the $10,000 in Treasury bonds to the lender and agreeing to repurchase them, say, in a year, at $10,700. This sale with a contract to repurchase at a price $700 higher than the original sale is essentially identical to borrowing $10,000 for one year at 7% interest.

See? That’s a repo or repurchase agreement.

It’s how banks borrow most of their money when they are temporarily shy of their reserve requirements.

But just to complicate matters, we’re being told that the Fed is contemplating removing money from the system using “reverse repos.” You, too can sound like an MBA using nonsense terms.

A “reverse repo” is exactly the same as a “repo,” just from a different perspective.

When the Fed is putting money into the system by buying from and then agreeing to resell securities to a bank, that’s a repo from the Fed’s perspective and a reverse repo from the bank’s perspective.

When the Fed is sucking money out of the system by selling and then agreeing to repurchase securities from a bank, that’s a reverse repo from the Fed’s perspective and a repo from the bank’s perspective.

Sheesh.

So when you read that the Fed is contemplating half a trillion dollars of reverse repos, that means that they’re trying to suck out half a trillion dollars from the economy by selling Treasuries to the banks with agreements to repurchase them later at a higher price.

But you don’t just suck out half a trillion dollars or more from the economy and pay it back in a couple months (the typical repo is for a few days to a few months — almost never longer than a couple years).

So the Fed is actually thinking of multi-year reverse repos. Two, three, four or more years. They dumped a lot of money into the economy and it will take years, after they’ve cleaned it out of the economy, to put it back in.

The skinny is this: you should care. Everything you hear about the economy is “maybe things are getting better” and “maybe the recession is over.” That’s all guesswork and feel-goodies. When the Fed actually starts putting reverse repos out there, then you know they’ve decided the economy’s growing and it’s time to lower the money supply heat. Every business and consumer decision you make is based on where the economy is heading. No huge Fed reverse repo program: we’re still heading south. The Fed chasing down hundreds of billions of dollars of reverse repos: the economy’s growing.

Of course, the Fed may have made the announcement just to make people feel good without actually doing anything. Alan Greenspan made a career of feel-good statements and do-nothing policies.

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2 Responses to “So what exactly is a reverse repo and why should I care?”

  1. Dave in Chicago says:

    Great article. Read it to my wife and she ALMOST didn’t fall asleep – she actually humored me and listened. I built a system to verify the adequacy of collateral for my Company’s (big bank with mutual funds like the type the Fed is looking at) repo line of business so actually LOOK for articles about this horribly dry but critical corner of modern finance. I bet only a few percent of people have a clue this is going on – even among the CPA’s out there. We need more people like you putting out simple explanations so folks will realize how scary an “efficient” balance sheet can be for companies (other than mutual funds with cash that has to go somewhere) that try to finance working capital with these types of short-term products that are definitely NOT guaranteed to be available 2 days from today. Just ask the folks at Lehman, who were squeezed when their collateral tanked, creating a great sucking sound as their short-term financing flew off their balance sheet. $188 BILLION in repo financing if you are to be believe the internet. btw – fortunately my company is a very old and very conservative institution and has weathered the whole financial mess very very well. It is good to know that not all financial institutions operate like the ones we have been reading about over the past year and I am proud to work at mine. but anyway – I’ll stop back and look for more good stuff…

  2. DJ says:

    I am not an economist, hence I am reading the article (good stuff). However, when the Fed says it wants to use money market funds to do this reverse repo I get a little nervous. I have money market funds, so basically the Fed is saying to me, Let me take your cash and I will give you one of my Treasury notes for now and come back later and give you your money back.
    If I wanted Treasuries I would have bought Treasuries. Or if I wanted bad mortgages I would have bought bad morgages. My faith in being repaid by the Fed with a strong dollar is diminishing.

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