The Federal Reserve, 'Repo' Rates, and Much Ado About Nothing
In August of 2008 Jimmy Lee, J.P. Morgan’s legendary financier, quietly let Blackstone CEO Stephen Schwarzman in on a harrowing truth: for three days the bluest of blue chip banks “hadn’t been able to roll over its commercial paper.” And it wasn’t just J.P. Morgan whose assets were no longer wholly trusted. The since-deceased Lee told Schwarzman that Bank of America and Citi were in a similar situation.
As Schwarzman recalls in his unputdownable memoir, What It Takes, Lee’s secret admission was more than disturbing. As the Blackstone co-founder described it, “These are the loans that corporate America lives on, the most liquid kind of debt, used to run their operations.” It’s a reminder of what Ken Fisher regularly reminds readers: in 2008 financial institutions weren’t insolvent (their assets were to a high degree performing as banks as a rule must generally lend toward and own “sure things”) as much as they were illiquid. For a time, lenders quite simply didn’t trust the assets of major U.S. financial institutions.
Schwarzman goes on to report that J.P. Morgan and others ultimately sorted their situations out “by offering extra protections to the other banks and institutions that lent to them,” but it was a sign of something bigger to Schwarzman: “if the biggest banks in the country had to hustle to get short-term loans to pay their bills, this problem had gone way beyond subprime mortgages.” Schwarzman’s recollections are very relevant to today’s hysteria about “repo” financing.
They are because as many readers are aware, last fall there was very briefly what some would refer to as "trouble" in the repo market. More specifically, on September 17, 2019 repo rates soared dramatically. Since then this occurrence has led to all manner of panicked writing about how the simple “plumbing” of the financial system is problem-ridden, and potentially vulnerable to a “crisis” inducing crack-up. Mises Institute senior editor Ryan McMaken lamented the “repo market's ongoing need for easy Fed money,” and then a Bloomberg headline described the brief spike in the fall as a “Crisis Decades In the Making.” In truth, and like most things that excite the minds of financial reporters and commentators, this was much ado about nothing.
For background, it’s worth adding to Schwarzman’s explanation of the commercial paper “loans that corporate America lives on.” As my friend Seth Levine (Levine is a bond trader in New York with an excellent blog, The Integrating Investor) puts it, “repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.”
Looking back to 2008, the high quality bonds on the books of banks were no longer trusted as implicitly as they had been, thus the more challenging repo market. What happened in 2008 needs to be considered in light of all the hysteria today about a brief spike in overnight borrowing that allegedly threatens the financial system, and that has engendered all manner of Fed injections of liquidity into the repo market. It says here that as opposed to something that readers should stay up at night worrying about, this is in truth yet another example of just how desperate the Fed is to stay relevant. Translated, all the hysteria is yet again much ado about nothing.
To see why, readers need only ask a basic question: What if, unlike its frenzied liquidity injections at the moment, the Fed's not a player in the repo market? Or what if it's not active? Presumably the cost of overnight financing soars on occasion, thus creating a profit opportunity for cash sources. If so, great. Markets at work. As Levine calmly put it about lending-rate spikes, “Arbitrage should render this behavior anomalous.” Translated, if overnight interest rates skyrocket on occasion, the soaring price, like the soaring cost of anything else, represents a very profitable opportunity for those long the market good (whether gasoline, hotel rooms, or money) presently in short supply. High prices in a market economy beget lower prices as market actors rush to meet the presently unmet need.
Looked at through the prism of the repo market that has the pundit and financial reporting class up in arms, the brief spike last fall and the much more harrowing and longer spike in overnight borrowing costs in 2008 is yet another reminder that the Fed can only confirm reality, not reshape it. To see why, consider Lee’s sotto voce admission to Schwarzman once again.
J.P. Morgan had a three day stretch where it hadn't been able to secure routinely cheap overnight financing. And isn't that the point? For a time highly risk averse lenders seeking the surest of sure bets (overnight lending is the next step up from cash in terms of risk) found themselves not even trusting the gold standard among U.S. banks. Crucial here is that market actors shut off Morgan, and there was little the Fed could do about it.
The lenders in the repo space (including the Fed) can surely participate in and help liquefy any kind of market, one defined by inexpensive financing (short-term, secured by quality assets), but markets ultimately assess every player individually. Much as banking conspiracy theorists from the Modern Austrian School wish it otherwise, allegedly “easy” Fed money can't create easy overnight borrowing for banks, nor can it bend the repo market to its liking. Ultimately a non-market player like the Fed can only confirm what's already happening in the marketplace as this column regularly argues.
If readers doubt this, they need only ask themselves a basic question: What if it's 2008 again? Does anyone think the Fed, by virtue of being the Fed, can force lending rates back to normal? To answer the question readers need only ask yet again what if there's no Fed? Do repo rates occasionally shoot upward for all sorts of reasons, and does repo finance occasionally vanish? Yes on both. But the markets for it also freeze up with an active Fed as we saw in 2008, and also last fall. No matter what governments do, markets always express themselves. Thank goodness they do.
So while readers can rest assured that all manner of hand wringing will continue, and all manner of sniping between the intervention versus market crowds about how much or how little the Fed should involve itself in the repo market, the greater truth is that the focus on the Fed is unwarranted. And if readers ever doubt this truth, they should revert to first principles: once again, what if the Fed didn’t exist? If so, a normally stable market will occasionally reveal signs of panic to reflect changing market conditions. Just like things are now with a Fed constantly trying to remind us that it exists.
The central bank cannot rewrite reality no matter how much the interventionists and alleged free-market types tell you differently. Actual market signals always, always, always have their say. What happened last fall to the repo market? Who knows, and who cares? What’s important is that so long as a desirable market good is in short supply, readers can rest easy that someone eager to make a buck will soon enough fix the supply imbalance.