On my somewhat complicated post on negative rates of return from last week, Robert Sams writes :

Very interesting post and #5 is crucial (it’s a geometric process). Two points.

1. I think that we can substitute “ability to leverage at near-treasury rates” for “special trading technologies” and get the same implied predictions yet put the relevant institutional factors into relief.

2. Your #1-3 still works with the wrong model of Treasury returns, as it implicitly models demand as if it’s coming from a “real money” portfolio sort of buyer. Those guys exist of course, and they’re basically buyers at any price (central banks, regulatory demand, etc.). But if we ignore CB policy expectations, the valuation is set in the leveraged market, which is much larger, and treasuries trade rich /not/ so much b/c people want safety and therefore want to buy them, but rather they trade rich because people want to /short/ them for hedging purposes (e.g. investor wants corporate credit w/o the interest rate risk.)

Sounds paradoxical, I know, but failure to appreciate this fact is the basic misconception of the entire “risk premia” way of modelling this stuff.

For any given treasury issue, X billion were sold by Treasury, but the outstanding amount of people long the issue will be many times X because of all those repo leveraged buyers of UST’s, and for every one of those repoed longs, there is a short on the other side doing reverse repo. The market clears with the repo rate, which can often be much lower than fed funds and indeed can go up to -300bps at times if the (primarily hedging) demand from shorts is extreme. (The effective repo rate in this market is rather different from the general collateral series you can pull from public sources. it’s hard to get good data as it’s proprietary to the big IDB’s… why the Fed tolerates this degree of opacity, I’ve never understood.)

Treasuries can therefore be seen as a special financial “currency”, and the treasury market can be modeled as type of free banking regime, where the public debt is base money, the much larger qty of leveraged UST positions is broad money, and the repo market is an interbank lending market where USD cash is collateral instead of money.

Looked at this way, the phrase “shadow banking system” is a quite literal description. Turn a market monetarist lose in this parallel universe, and the low rate conundrum is due to UST “base money” not keeping up with demand and the Treasury is a tight fisted CB.

In this universe, the real return of treasuries isn’t the relevant variable, it’s the spread between the repo rate and the treasury yield, which acts as a sort of “fee” for the guy who wants a hedged Investment in a riskier asset and pari passu a benefit to the party who wants a leveraged bet that the Fed means what it says about ZIRP. In finance-land with its UST currency, that spread /is/ the ST interest rate, which is volatile and well-above zero.

Now we can define quite precisely your “entry fee” thesis: the entry fee is the relative credit terms (haircut’s, etc) you’ll get in this repo market. In a world of only non-bank dealers and traders, those terms are symmetrical b/c counter-party risk is broadly symmetrical. In the world of TBTF, naturally only the bank holdco’s get the best terms. So, to win the wealth-accumulation game in this world, be a bank or be a very good client of a bank.

Ponder at your leisure!

24 comments

derek December 15, 2013 at 3:02 am

Just trying to figure this out. A repo is an agreement to sell a security and repurchase it at a future date, the spread being the difference between price sold and price bought. A reverse repo is the other side, an agreement to buy and resell at a future date.

So the US treasury is purchased from the Treasury in an auction by a primary dealer, who are also typically the large banks. They can sell in a repo agreement, and get some cash in return to do some investment of some sort, more than likely something which yields higher than UST, something more speculative and probably offshore. Is the multiple because the buyer now has a treasury bond, and can enter into a repo agreement, the next buyer doing the same again and again? The same bond being sold multiple times in repo agreements?

The counter parties would have to be counted upon to be able to repurchase at the agreed time. You definitely wouldnt want anyone who doesnt have deep pockets or the ability to raise capital to fulfil the repurchase side of the agreement.

When the Fed buys up a portion of the Treasuries of a certain duration, they change the price of those bonds, keeping the prices high and the yields low. Essentially providing a stable asset price to be used in these repo markets. I suppose that explains the sudden change in interest rates when they said they were going to taper off the purchases; the price change would have a cascading effect in these repo markets, creating a flurry of unwinding positions so participants would not be stuck with higher costs than expected.

Is this how banks get overnight cash to fund their positions? I remember reading about the bond trading company Kantor Fitzgerald whose offices were destroyed on 9/11 needing to negotiate with one of the big banks at the end of the day to borrow $80 billion or so to fund the bonds that they purchased and were holding at the end of the day. I suppose they had to put up some collateral, selling some of the bonds to the bank with an agreement to repurchase in the morning so they could continue trading.

ChrisA December 15, 2013 at 5:59 am

It seems very similar idea to the multiple tranche mortgage bonds of the last decade, where a very simple risk model (house prices never fall nation wide) was used to change junk bonds into high quality bonds that could then be used by IBs to further increase their leverage. The point of all this was to go beyond the leverage allowed by regulators. My guess is that, like the housing bond crisis, there is a tail risk here which is not being considered or is actually being hidden (hey while the music is playing you have to dance).

It is too complicated for me though to figure out the hidden risk and I bet for regulators and the vast majority of retail investors. Which is probably the point. Seriously the financial industry is great at creating opacity by which means they can fleece the agents of primary investors (i.e. the people running pension and mutual funds). Agents are suckers for IB brand names as it means that they cant be blamed if something goes wrong, especially if the regulators are allowing the process. Everyone wins, the agents get to boast of higher returns and keep their cushy jobs, the IBs get to leverage up again and get their bonus and everyone hopes that the house of cards keeps going until they can quit. Of course retail investors are ultimately the ones who will carry the can, but of course they will go running to Ma Fed.

Laura December 15, 2013 at 12:17 pm

The highly rated tranches of MBS did very well in the end. Their high rating had more to do with their seniority in the debt structure.

Rahul December 15, 2013 at 6:03 am

Wow, now thats a complex & rich comment! Robert Sams really does seem to know what hes talking about.

I read Robert Sams comment a couple of times but only understood perhaps 20% of what hes trying to say. Can someone produce a for dummies elaboration of his comment?

Rich Berger December 15, 2013 at 7:47 am

Yes, a very interesting comment. Clearly, participants in these markets know what they are trying to do, even though they might fail to appreciate the big picture. What I would like to know is what the rates of return are for the investments that are the object of the entry fee, and what sorts of investments these are.

derek December 15, 2013 at 10:23 am

I think the failure of the trading firm that Jon Corzine was involved in showed some of the entry fees. To do a trade as an outsider you had to post collateral of some kind, cash or something else. When this firm went bankrupt, investors found that not only did they lose on the trade, but that the collateral had multiple liens against it. It probably isnt an entry fee as such, rather a privilege that the large banks have. They can move your collateral to a less stringent regulatory environment, do multiple repo deals on it, while you or I as investors have to deal with the window dressing and low or non existent returns.

F.F. Wiley December 15, 2013 at 9:33 am

Great comment. Manmohan Singh is another whos been writing about similarilities in the money creation capacity of high quality collateral vs. reserves held at the Fed, and the notion that high quality collateral effectively acts as base money. Shadow banking doesnt get enough attention. Heres an example from Singh:

I think the original post needs clarification from #10 “tighter monetary policy would simply add another problem … without curing the underlying dysfunctionality.” Add another problem, yes, by hurting both the economy and public finances in the short-term, but most people would see tighter policy as raising the real return on safe assets and reducing the advantages to those with “special trading technologies.”

ZIRP, QE and forward guidance are all holding real yields on safe assets down, as intended by the Fed alongside its twin objective of holding real lending rates down. This is one piece of the common argument that Fed policies are partly to blame for rising inequality, but the first post makes the link from real yields to inequality without the additional link from real yields to monetary policies (apart from forward guidance). IMO this needs further explanation.

Bill December 15, 2013 at 9:36 am

In reading this, I wonder if the writer is simply describing the acceptance of a lower return, negative return, on one class of assets to hedge the potential gain and risk on another class of assetswhich could happen anytime, and not just when rates are close to zero. For example, if the interest rate were 6%, and you were willing to take an asset that had a 4% return.

This discussion of negative interest rates has been something that has appeared as discussion points in Europe recentlyprobably because if you have austerity as a policy, all you are left with is monetary policy, and there is little elsewhere you can go than below zero if you want to do something to stimulate.

Or, you can raise a minimum wage, as they are considering in Germany.

prior_approval December 15, 2013 at 10:06 am

Or, you can raise a minimum wage, as they are considering in Germany.

Well, now that the SPD has agreed to be in the government, it is a done deal. On the other hand, dont expect to read too much about it here.

derek December 15, 2013 at 10:27 am

Sure, but if the safe rates are below inflation people are forced into a situation where they either lose money or do these risky and systemically fragile things to get a return. If you are a pension fund or insurance, you have to get a return or you cease to exist.

Bill December 15, 2013 at 10:48 am

Derek, The trader described a profit making strategy by assuming a negative rate on a class of assets for the purpose of being able to assume more risk on another class of assets.

derek December 15, 2013 at 11:08 am

Sure. But would they be doing it if a 20 year mortgage was 8%? Or UST was at 5.5%? Some would, with a target in the double digits. The shadow banking system is at least as large as the regulated one, if not quite a bit larger.

If you fix the price of bread below cost, farmers go out of business or start operating in the black market. Or line themselves up a politician with a hand in the revenue stream. And poor people go hungry.

I know why the Fed and other monetary authorities are doing this. If they didnt set the price, the market would set it. The value of assets would plummet, costs would start to reflect the risk. The economy would shrink by some ungodly number, along with the revenues of government. An ugly mess. This is how the Japanese lost decade or two happens.

Bill December 15, 2013 at 11:41 am

derek,

Two questions:

1. If interest rates decline, what happens to the value of an 8% bond you referred to. Does it increase or decrease. Now that youve answered that question, answer the next one.

2. Has Warren Buffets insurance business done well during this period. If he has done well, that may tell you something about the ability of well managed insurance companies to operate in changing interest rate environments.

3. If you are AIG, nothing will help you if do not have good risk management policies.

Laura December 15, 2013 at 12:24 pm

Bill, regard AIG that depends on your definition of risk management. They had poorly structured CDS contracts which required them to post a large amount of collateral.

The underlying transaction separate from that matched their models in the long run, and thus the basis of their lawsuit against the Fed and US treasury for misappropriating their assets for the benefit of the European banks would have faced a collateral crisis if AIG had gone through a normal bankruptcy process (from which it would have emerged with the shareholder intact).

derek December 15, 2013 at 8:00 pm

Again, sure. The assets are overvalued. The price of MBSs are adjusted by the Federal Reserve buying them, artificially inflating the prices.

As the original article describes, if you have assets, and if you are in the club, you do very well. The Fed will maintain the value of the assets, and with that assurance you can use them as collateral to get real returns. If you arent in the club, they will take your assets as collateral, do the same thing for themselves with those assets, while you take the risk, or get no return at all.

And the investment that is generated happens elsewhere, in other countries where there is a possibility of returns, causing all kinds of distortions in those markets, while a minor notch down in the unemployment rate is heralded as the Great Recovery back home.

I dont know what Buffet is doing to generate returns in his insurance business. The financial sector in the US seems to be doing pretty well. ZIRP and QE seem to be the new normal, and both permanent. The Japanese bond traders did ok during all those years of stagnation, with a carry trade and depending on deflation for yield.

It seems to me extraordinarily fragile. A vague hint that QE was possibly being considered to taper a tiny bit created a huge asset price drop and turmoil in the foreign markets that benefit from the created investment. We have China and Japan throwing mean words back and forth right now. This wont turn out well. The only hope is that Im gone before all hell breaks loose, but that is scant comfort for my children.

Lee A. Arnold December 15, 2013 at 11:41 am

Sams description loses me at the point where he appears to invert the Treasuries into shadow currency, base money, for modeling purposes. I think it is simpler that that, and a flow-chart language can show the situation.

www.youtube.com/watch?v=7tTapPEhOKg&list=PLT-vY3f9uw3ADgyYqUVo2R8kxM4Agc3aw&index=17 and the one which automatically follows it, Types of Financial Derivatives.

I found that repo is shaped like the federal funds market among depository banks: Repo is overnight lending to meet current obligations and find funds for new financial investments (i.e. not necessarily real, nonfinancial, investments). According to Gary Gorton and others, the repo market collateral was about half Treasuries and half AAA mortgage derivatives, until the mortgage derivatives collapsed in the crisis. Since Treasuries have maturity dates, the need for fresh Treasuries as repo collateral remains high, thus the price stays up.

www.youtube.com/watch?v=wHoRYAv1wg8&list=PLT-vY3f9uw3ADgyYqUVo2R8kxM4Agc3aw&index=1

So, a simple flow-chart story suggests TWO DIFFERENT causes of very low interest rates: 1) high demand from shadow-banking for Treasuries as repo collateral, and 2) the liquidity trap, which is due to two different things itself: a) the worldwide savings glut and b) the (hopefully temporary) loss in consumer demand.

Bill December 15, 2013 at 1:52 pm

+1, but not what the audience wanted to hear: liquidity trap and loss of consumer demand.

Oh, my.

MG December 15, 2013 at 12:47 pm

Victoria Hilsenrath December 15, 2013 at 3:47 pm

Sorry, forgot to include this link on the reverse repo facility:

Robert Sams December 15, 2013 at 10:53 pm

Short answer: 1. Yes (probably) and 2. Who knows.

If you accept the thesis that USTs are a medium of exchange in the financing market, then the facility is an ideal tool for purposes opposite of its advertised function (raising st rates to control inflation), for base money is both USD reserves and UST supply, so reverse repoing is swapping one MOE where the multiplier doesnt seem to work for another MOE where it does seem to work. Thats the conjecture at least, spun as a market monetarist reconciled with an institutional story about how our identification of money and its multiplier needs to change to reflect the facts on the ground about how credit really happens. (I know, I know it sounds like those old m2 m3 debates all over again, but money and credit are more elusive notions than economists care to admit.)

But if you dont care about money and think its the ST rate that matters then its all about whether the facility can get the market to trade the Fed funds rate (or a new benchmark repo rate, which seems to be the thinking of some bright sparks in the Fed. a wholly sensible idea that acknowledges the facts on the ground) where the Fed wants it to trade. I dont see any reason why this wouldnt work. But then the same could have been said about IOER, which we all learned wasnt quite the dog to wag the tail of fed funds effective (my how that must have puzzled the money market boffins in fed research. Often the simple things are the most perplexing.)

Still confused after reading all these comments about what is the purpose of this. Someone is buying an asset at more than it should cost, so that he can lend the asset to others for a fee (that presumably makes up for his initial loss)? Then the guy borrowing this asset is also able to make money by lending the borrowed asset again. And this continues indefinitely? But who ends up with the asset at the end of the day and why didnt they just buy it themselves at the original price? Banking should be basically boring and easy to understand. When it is not, it is a con on you and me. Simple rule.

Brian Donohue December 16, 2013 at 9:28 am

HmmmWhat Would Sumner Say?

mark December 17, 2013 at 2:10 pm

Never saw the original post til now, want to now offer a couple thoughts.

Tend to agree with the entry fee observation, although I wouldnt use that term, because it applies to long-standing firms even more so than new entrants. Two practical observations in this regard:

1) Once youre holding cash in the quantities that large firms do, printing it out ceases to be an option, so you have to buy/lend some sort of cash equivalent. You have to pick the best practical option, not the best theoretical option. As you observe, the firms that have this problem also have lots of other assets so the minor cost of a negative TBill return can get born, like other costs of doing business.

2) There are all kinds of contracts, particularly derivatives, and also corporate or mutual fund investment policies, that have specified limited rosters of permissible cash equivalents, Their definition of cash equivalent reflects decades of experience when rates were higher. No one ever thought to plan for the day when rates were zero. But it is not efficient to go about changing them to avoid what is a relatively small cost that is expected to evaporate in the medium term. Transaction costs > loss from continuing with past practice.

Comments on this entry are closed.