Learn about Repurchase Agreements - Repo transactions Video

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Learn about Repurchase Agreements - Repo transactions

Let's say that you're in desperate need of money and I have money to lend to other people. So this is me and this is my gold chain. So you come to me and say “Sal, I need $10,000.00 for a kidney transplant. Can you lend me the money I'm in desperate need?” So what would you need $10,000.00. And now I have $10,000.00 and I was “Sure, I will lend to you but you know it’s a tough economy and you never know where that money is going to go and I don’t know if you're going to be able to keep your job after you know going through this kidney surgery and all that. So I'm you know, I'm very careful with my money, so I want to make sure that you're good for it.” So we think about it a little bit and I say “Hey, you know that what you have on your wrist that looks pretty nice” and you say “This watch?” and I say “Yeah, that watch” and you’re like “Oh, you know this watch I got from great, great grandfather and it's actually worth I don’t know maybe it's a diamond studded Rolex, so of some sort. And it's actually worth $30,000.00”. And I know that clearly because I've already become well acquainted with gold and diamonds and things like that. So I say “You know what, I trust you. And you trust yourself, I’ll give you the $10,000.00, I’ll lend you the $10,000.00. But just so that we all know that everything is going to be fine, why don’t you just leave your great grandfathers watch with me and if when you pay back the $10,000.00 with a low interest. Let's say it's I don’t know 10% a week, 10% per week. When you pay it back the money, the principle with the interest however long you borrow it, I’ll give you back your watch” and you know like “Oh, I don’t know about that you, you know, first of all 10% a week sounds a lot” and I was like “Oh, don’t you just need it for the kidney transplant tomorrow and then you can work a couple of weeks and then pay it back 10% a week is not bad and we all know that that is because you compound that over the year it becomes some type of a horrendous interest rate”. But you're desperate you need your kidney and I’m like look “You plan on paying me back right, so you're going to get your $30,000.00 watch back so what's there to worry. So why don’t you just leave this with me as collateral” and you would say “Fine” and you leave your watch and you get your kidney transplant and then you try to work really hard to pay it back but you never can and I keep your watch. And this is how the pawn process essentially works. You pawned your watched off to me but in a less kind of the derisive way of talking about it, you’ve given it as a collateral for a loan. And I was willing to give you the loan because I knew that if you couldn’t pay it I can keep this nice asset. And this happens all the time in less shady parts of our economy, a bank will give a loan and they’ll collateralize it by the house. If you can't pay the loan they keep the house. They want you to put a down payment on the house so that even if the house devalues they still captor back most of their money. And so this is a pretty straight forward collateralize loan. This is the collateral you give me, I give you the loan you pay it back, I give you back the collateral. Now, what if there was a reality, well I don’t even you know, me as the lender. I don’t even like this notion of collateral and all of that. I actually want to make it very clear that I have ownership of the collateral when it happens. I don’t want some feds coming in and saying “You know, whose watch that is this that you're holding” you know, “Where’s the receipt for this? Where did you get it? Was it stolen from somebody?” and you know you looks all shady and I probably do have some side shady operations. Anyway, so I want to know that I owned this watch in the event that you don’t come back to pay the loan. So instead we could have done this exact same transaction, so this is you again and this is me again. And now what I can do is because I want ownership of that watch. What I’ll do is I will buy that watch from you, so you’ll give the watch. So the watch will literally change ends. I’ll buy the watch from you for a $10,000.00 and I get the watch, you get the money. But we’ll also have a side agreement. Well suppose so far it's almost identical right, the only difference this in what we did before is I'm actually selling the money. I'm actually selling the watch to you; I'm actually buying the watch from you. This was a cash transaction, this wasn’t a loan strictly speaking, but the same thing is happening. Up here you handed me the watch and I handed you $10,000.00. Here you handed me the watch and I handed you $10,000.00 but what we’ll add on to this is an agreement, that at some future date you're going—so this is now, we also going to have an agreement and both of us are parties to this, that in the future I will agree to sell and you will agree to buy this watch from me for something more than $10,000.00. So in the future you're going to give me back my money. So it will be $10,000.00 plus something and that something is essentially interest. So all I get my money back and then I’ll give you back the watch. So if you think about it, this is completely identical economically to what we did up here. I give you $10,000.00 you gave me that watch as collateral when you pay back the $10,000.00 plus interest I give you back the watch. Right, but at no time did I really have real legitimate ownership of that watch? Well in this situation I have complete legit as same thing happens. You come to me I give you money, you give me the watch but I bought it from you so I have a receipt too. I am the official owner of the watch while you have my money but we have an agreement that at some future date you will repurchase the watch from me. You will repurchase the watch right here. So you will repurchase the watch from me for $10,000.00 plus some amount which is essentially the interest. So this was a loan collateralize by watch but the only difference here, is that instead of it just being collateral you actually sold it to me and then we had a repurchase agreement and it took me six minutes to say that but I think it was worth it. We have a repurchase agreement, repurchase agreement where you agree to repurchase the watch at some point and it's actually, I'm the holder of the repurchase agreement, so the money lender, the lender, so I get the watch and the repurchase agreement we’ll call that a repot. So these are two assets that I now have, the watch plus the repurchase agreement. You get the money and it's actually called a reverse repot from your point over view, reverse repot. But the whole idea here is this agreement forces you to buy the watch back at the original amount that you essentially borrowed from me plus some interest. And this essentially forces me to sell it to you. So we have it's essentially a forward contract, a forward contract is just an agreement to transact in the future at some given price. And the whole reason why I did this is because this is how the fed transact. This is how the fed lends specially with the discount. This sometimes it's called the repo transaction or a repurchase agreement. And so what the fed does when someone comes to it at the discount window and let's say, let me actually draw proper balance sheets now. Let's say that this over here is a bank in need. I won't worry about the right hand side of the balance sheet too much. It has some liabilities, some equities. Let's say it has a ton of assets and let's say that these rights here are treasuries. But it's all out of cash, this is the bank. It's all out of cash and on the other hand we have the fed, we have the Federal Reserve let me see if I can draw they're balance sheet properly. And the Federal Reserve it can, well for the most part these are going to be treasuries right now. It has some liabilities; I won't go into that just yet. It has some equity and if it's going to and let’s say you're one of this prior banks no one’s willing to lend to you, your depositors are taking out their money. So you need to convert some of these treasures into cash, you don’t want to just dump them on the market maybe there are other assets that are less liquidity and if you just dump them you won't get the value you want. So essentially you enter into a repurchase agreement with the Federal Reserve. You go to the Federal Reserve discount window; the discount rate might be 5% on an annual basis. But we won't get into the technicalities of that. You say “Hey, fed lend me some money” and the fed says “Okay, let me print some money for you” so this are the liabilities notes outstanding and then it print some Federal Reserve notes. But instead of just lending the money to you and then keeping these treasuries as collateral, the Federal Reserve will actually buy this and you’ll enter into a repurchase agreement with you. So let set the mechanics of that are, is that the Federal Reserve will buy these treasuries from you. So now, all of the sudden the treasuries let me see if I can do it. So the Federal Reserve notes will go from, from the Federal Reserve to you and then your cash will go to the and then your treasury notes will go to the Federal Reserve, this is cash. Federal Reserve printed cash gave it to you and then essentially bought treasury notes from you, so now these are treasury notes. These are the treasury notes that were behind that were here before. I mean it has a repurchase agreement where you agree at some future date to unwind this transaction, where you're going to buy back your treasuries and you're going to pay the amount that the treasury paid you initially plus some interest. So the basic way to view it is this was just a loan. You just borrowed this much from the Federal Reserve. And the Federal Reserve kept your treasuries as collateral but it actually had formal ownership over it and that what differentiates a reverse, not a reverse. That’s what differentiates the repo agreement from a just a traditional collateralized loan. But in the future, you're going to buy back those treasuries for the amount the Federal Reserve had originally bought them from you for plus a little bit of interest. You're going to pay a little interest and that interest is going to be dictated by the discount rate. Anyway, all out of time, in the next video actually look at the Federal Reserves balance sheet.

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Let's say that you're in desperate need of money and I have money to lend to other people. So this is me and this is my gold chain. So you come to me and say “Sal, I need $10,000.00 for a kidney transplant. Can you lend me the money I'm in desperate need?” So what would you need $10,000.00. And now I have $10,000.00 and I was “Sure, I will lend to you but you know it’s a tough economy and you never know where that money is going to go and I don’t know if you're going to be able to keep your job after you know going through this kidney surgery and all that. So I'm you know, I'm very careful with my money, so I want to make sure that you're good for it.” So we think about it a little bit and I say “Hey, you know that what you have on your wrist that looks pretty nice” and you say “This watch?” and I say “Yeah, that watch” and you’re like “Oh, you know this watch I got from great, great grandfather and it's actually worth I don’t know maybe it's a diamond studded Rolex, so of some sort. And it's actually worth $30,000.00”.

And I know that clearly because I've already become well acquainted with gold and diamonds and things like that. So I say “You know what, I trust you. And you trust yourself, I’ll give you the $10,000.00, I’ll lend you the $10,000.00. But just so that we all know that everything is going to be fine, why don’t you just leave your great grandfathers watch with me and if when you pay back the $10,000.00 with a low interest. Let's say it's I don’t know 10% a week, 10% per week. When you pay it back the money, the principle with the interest however long you borrow it, I’ll give you back your watch” and you know like “Oh, I don’t know about that you, you know, first of all 10% a week sounds a lot” and I was like “Oh, don’t you just need it for the kidney transplant tomorrow and then you can work a couple of weeks and then pay it back 10% a week is not bad and we all know that that is because you compound that over the year it becomes some type of a horrendous interest rate”.

But you're desperate you need your kidney and I’m like look “You plan on paying me back right, so you're going to get your $30,000.00 watch back so what's there to worry. So why don’t you just leave this with me as collateral” and you would say “Fine” and you leave your watch and you get your kidney transplant and then you try to work really hard to pay it back but you never can and I keep your watch. And this is how the pawn process essentially works. You pawned your watched off to me but in a less kind of the derisive way of talking about it, you’ve given it as a collateral for a loan.

And I was willing to give you the loan because I knew that if you couldn’t pay it I can keep this nice asset. And this happens all the time in less shady parts of our economy, a bank will give a loan and they’ll collateralize it by the house. If you can't pay the loan they keep the house. They want you to put a down payment on the house so that even if the house devalues they still captor back most of their money. And so this is a pretty straight forward collateralize loan. This is the collateral you give me, I give you the loan you pay it back, I give you back the collateral.

Now, what if there was a reality, well I don’t even you know, me as the lender. I don’t even like this notion of collateral and all of that. I actually want to make it very clear that I have ownership of the collateral when it happens. I don’t want some feds coming in and saying “You know, whose watch that is this that you're holding” you know, “Where’s the receipt for this? Where did you get it? Was it stolen from somebody?” and you know you looks all shady and I probably do have some side shady operations. Anyway, so I want to know that I owned this watch in the event that you don’t come back to pay the loan.

So instead we could have done this exact same transaction, so this is you again and this is me again. And now what I can do is because I want ownership of that watch. What I’ll do is I will buy that watch from you, so you’ll give the watch. So the watch will literally change ends. I’ll buy the watch from you for a $10,000.00 and I get the watch, you get the money. But we’ll also have a side agreement. Well suppose so far it's almost identical right, the only difference this in what we did before is I'm actually selling the money. I'm actually selling the watch to you; I'm actually buying the watch from you. This was a cash transaction, this wasn’t a loan strictly speaking, but the same thing is happening. Up here you handed me the watch and I handed you $10,000.00. Here you handed me the watch and I handed you $10,000.00 but what we’ll add on to this is an agreement, that at some future date you're going—so this is now, we also going to have an agreement and both of us are parties to this, that in the future I will agree to sell and you will agree to buy this watch from me for something more than $10,000.00.

So in the future you're going to give me back my money. So it will be $10,000.00 plus something and that something is essentially interest. So all I get my money back and then I’ll give you back the watch. So if you think about it, this is completely identical economically to what we did up here. I give you $10,000.00 you gave me that watch as collateral when you pay back the $10,000.00 plus interest I give you back the watch. Right, but at no time did I really have real legitimate ownership of that watch?

Well in this situation I have complete legit as same thing happens. You come to me I give you money, you give me the watch but I bought it from you so I have a receipt too. I am the official owner of the watch while you have my money but we have an agreement that at some future date you will repurchase the watch from me. You will repurchase the watch right here. So you will repurchase the watch from me for $10,000.00 plus some amount which is essentially the interest. So this was a loan collateralize by watch but the only difference here, is that instead of it just being collateral you actually sold it to me and then we had a repurchase agreement and it took me six minutes to say that but I think it was worth it.

We have a repurchase agreement, repurchase agreement where you agree to repurchase the watch at some point and it's actually, I'm the holder of the repurchase agreement, so the money lender, the lender, so I get the watch and the repurchase agreement we’ll call that a repot. So these are two assets that I now have, the watch plus the repurchase agreement. You get the money and it's actually called a reverse repot from your point over view, reverse repot.

But the whole idea here is this agreement forces you to buy the watch back at the original amount that you essentially borrowed from me plus some interest. And this essentially forces me to sell it to you. So we have it's essentially a forward contract, a forward contract is just an agreement to transact in the future at some given price. And the whole reason why I did this is because this is how the fed transact. This is how the fed lends specially with the discount. This sometimes it's called the repo transaction or a repurchase agreement. And so what the fed does when someone comes to it at the discount window and let's say, let me actually draw proper balance sheets now.

Let's say that this over here is a bank in need. I won't worry about the right hand side of the balance sheet too much. It has some liabilities, some equities. Let's say it has a ton of assets and let's say that these rights here are treasuries. But it's all out of cash, this is the bank. It's all out of cash and on the other hand we have the fed, we have the Federal Reserve let me see if I can draw they're balance sheet properly. And the Federal Reserve it can, well for the most part these are going to be treasuries right now. It has some liabilities; I won't go into that just yet. It has some equity and if it's going to and let’s say you're one of this prior banks no one’s willing to lend to you, your depositors are taking out their money. So you need to convert some of these treasures into cash, you don’t want to just dump them on the market maybe there are other assets that are less liquidity and if you just dump them you won't get the value you want.

So essentially you enter into a repurchase agreement with the Federal Reserve. You go to the Federal Reserve discount window; the discount rate might be 5% on an annual basis. But we won't get into the technicalities of that. You say “Hey, fed lend me some money” and the fed says “Okay, let me print some money for you” so this are the liabilities notes outstanding and then it print some Federal Reserve notes. But instead of just lending the money to you and then keeping these treasuries as collateral, the Federal Reserve will actually buy this and you’ll enter into a repurchase agreement with you. So let set the mechanics of that are, is that the Federal Reserve will buy these treasuries from you.

So now, all of the sudden the treasuries let me see if I can do it. So the Federal Reserve notes will go from, from the Federal Reserve to you and then your cash will go to the and then your treasury notes will go to the Federal Reserve, this is cash. Federal Reserve printed cash gave it to you and then essentially bought treasury notes from you, so now these are treasury notes. These are the treasury notes that were behind that were here before. I mean it has a repurchase agreement where you agree at some future date to unwind this transaction, where you're going to buy back your treasuries and you're going to pay the amount that the treasury paid you initially plus some interest.

So the basic way to view it is this was just a loan. You just borrowed this much from the Federal Reserve. And the Federal Reserve kept your treasuries as collateral but it actually had formal ownership over it and that what differentiates a reverse, not a reverse. That’s what differentiates the repo agreement from a just a traditional collateralized loan. But in the future, you're going to buy back those treasuries for the amount the Federal Reserve had originally bought them from you for plus a little bit of interest. You're going to pay a little interest and that interest is going to be dictated by the discount rate. Anyway, all out of time, in the next video actually look at the Federal Reserves balance sheet.

Transcription by: Scribe4you Transcription Services