1988 - 2nd Quarter (3)
1988 - 2nd Quarter (3)
"Is a repo different from a loan?"
A-ra tilted her head.
It's not a common concept in the general market, so it's natural for ordinary people to think that way.
And since repos are products created to supplement the shortcomings of loans, it's understandable to be confused.
"Since collateralized loans most commonly use real estate, let's use that as an example."
Real estate is probably the easiest to understand.
"Let's say you borrowed $90,000 using a $100,000 house as collateral."
"Okay."
"Then who owns the house?"
"Well, me, right?"
I nodded.
"Correct. Because with a loan, ownership doesn't transfer."
"Is a repo different?"
"It is. If you fail to repay the loan, the bank needs a lot of effort and time to dispose of the real estate."
"They don't just take the house?"
"They have to hold an auction through the courts, and a winning bidder has to emerge. Moreover, if the winning bid for the house is less than the loan amount, they have to pursue collection again. At best, it takes half a year, and it can take years to recover the money."
"I've never thought about it from that perspective."
"I bet. Most people probably think banks are bastards."
To understand that, you have to think from the bank's position.
How many people in the world would bother to consider the bank's position?
But without banks, the capitalist market wouldn't function.
So it's good to know, I suppose.
"That's why the repo product was created."
"I see."
"Repurchase agreement bond. As the name says, it's a bond sold with a promise to buy it back."
It's a product that's exactly what it says on the tin, but A-ra tilts her head, finding it hard to grasp easily.
"You sell the house, promising to buy it back."
"Huh...? Then the bank takes the house?"
"Right. However, you can continue living in that house, only the ownership transfers to the bank."
"Hmm..."
"In that case, if it seems you won't be able to repay the loan, the bank can sell the house immediately. Because the house is under the bank's name."
Of course, that's using real estate as a metaphor; in reality, it's bonds, so it's not a perfect match.
"Now, let's replace real estate with bonds. U.S. Treasuries, for starters."
"Huh? Don't bonds pay interest?"
"You really hit the nail on the head!"
"Thank you."
A-ra gave a slight bow.
That was supposed to be my killer line.
Did I come on too strong?
A bit embarrassing.
I awkwardly scratched my cheek and spoke again.
"Ahem. You're right. Bonds pay interest. However, in a repo contract, while ownership is transferred, the right to interest payments remains with the original owner as long as the repurchase right is alive."
"Hmmmm-."
"Maybe repos are a bit difficult after all?"
"They are."
Maybe it's the terminology.
It's hard to give a clear, definitive explanation.
"Hmm... Maybe it's better to explain the strategy we're going to implement going forward."
"Strategy? You mean the one about living off the interest at Salomon?"
"Yeah. That one."
In a way, that might be better.
Seeing how it operates might make it easier to understand.
"So, we made $10 million from U.S. Treasury futures, right? Let's assume we're putting that in."
"Okay."
"We're going to buy with 30x leverage. A total of $300 million worth of 30-year U.S. Treasuries."
"Then, we buy the 30-year bonds and pledge them as collateral, and as you explained earlier, we use that as collateral to buy more 30-year bonds to increase the amount, right?"
"Correct. That's how we secure $300 million worth of 30-year bonds."
"I understand up to that point."
A-ra nodded.
"The 30-year U.S. Treasuries will pay interest, right? Let's assume we bought them at our target yield of 9.4%. Even if we sold them via repo, the right to the interest is ours. So, the interest we receive is?"
"$300 million... That's $28.2 million per year. Isn't that more than the trading profit?"
"Let's round it to $28 million for easy calculation. But since we pledged them as collateral, we have to pay interest, right?"
"So we pay the interest with the $28 million."
"The repo interest rate is the overnight LIBOR rate. You can think of it as roughly the base rate plus a bit extra. The current rate is 7.25%."
She blinked her eyes repeatedly for a while.
"So we receive 9.4% and pay 7.25%, is that it?"
"Yep."
"2.15%... Isn't that an arbitrage trade?"
"Basically, you can think of it as the same. You could call it a yield curve leverage carry trade strategy using the long-short interest rate differential."
"...Why does it have to be so long."
"You can just call it a yield curve carry trade. Anyway."
It's a strategy used quite a bit by hedge funds, but since it's not exactly textbook material, the names are all over the place.
"Calculated that way, the net profit is $6.45 million."
"It's not small, but... maybe because we've been dealing with such large figures lately, it seems small."
Has her sense of scale already grown?
After seeing figures in the tens of millions and billions, $6 million a year probably seems small.
It's a trap novice investors or traders often fall into.
"Looking at just that, one might not say it's that big."
Though, to be honest, it does seem a bit small to me too.
A 64.5% annual net profit, I mean.
"Now, what happens if the Fed lowers rates by 1%?"
"Then it becomes a 3.15% profit."
"And the price of the bonds themselves rises by 17%."
"Ah!"
You get the interest on one hand, and the bond prices themselves rise on the other.
Of course, that risen price includes the interest.
"If rates drop by just 1%, the profit becomes $9.45 million."
"...Hmm-."
"You can roughly recover your principal in about a year with a $10 million investment. The remaining 29 years continue to generate profit."
"Looking at it that way, it is pretty amazing."
Is it just 'pretty amazing'?
Hedge funds don't jump into bonds risking their lives for nothing.
There's no such thing in the world as a product that can consistently yield 100% annual returns.
There shouldn't be.
"High returns also mean high risk. Repos have margin calls too."
"What if the interest we pay becomes greater?"
"Good point, but no. That's called negative carry."
Positive carry is when the interest you receive is greater than the interest you pay; the opposite is negative carry.
When the outgoing interest expense is greater.
It occurs when the base rate is higher than the long-term bond yield.
"You've heard of the long-short yield curve inverting, right?"
"Yes."
"That's when it becomes negative carry. For people like us who borrowed short-term to buy long-term bonds, if the amount we have to pay increases, cases of disposing of the long-term bonds increase."
That's why they say an inverted yield curve is a sign of an impending recession.
They tried to curb inflation by raising short-term rates, but if long-term bonds flood the market, they might buy back the short-term bonds and drain liquidity.
"Well, that's a macroeconomic issue, so let's skip it for now."
Just explaining the carry trade is complicated enough to give you a headache.
"Margin calls occur when the value of the bonds themselves falls. If rates rise by 0.2%, you need more money than your principal."
"Doesn't 0.2% rise easily?"
"No. It goes up and down several times a day?"
"...Huh? Then a margin call comes the very next day."
"Right."
That's why David is foaming at the mouth trying to stop me.
"Oh, no. I thought Mr. David was doing that because he didn't trust you, Master."
"It's not a matter of trust. It's a strategy that only succeeds if you catch it right at the very peak. And since it's a carry trade, you must not touch it even once until it's liquidated."
Of course, I plan to buy at a level where I won't have to touch it for 30 years.
"Is that... even possible?"
"I don't know."
Even if there's a cheat key, I wouldn't know.
Nothing in the world is perfect.
"In the worst case, I'd even take out a loan to cover the margin call."
That's Plan B, at least.
But even then, if the situation has deviated enough to trigger a margin call, it would be like pissing on frozen feet.
The slightest failure would likely mean forced liquidation.
"Anyway, do you understand repos now?"
"For now, yes. I get that you pledge bonds as collateral to borrow money, then use that to buy more bonds. Repeating that to increase the volume. And the interest profit structure too."
"Good. Then you understand the difference from a loan?"
"Yes. But I still don't quite get the concept of buying it back."
"That's simple. On the bond's maturity date, the principal comes in, right? You use that to repay the borrowed amount, and that's it."
"Then do you have to hold it until maturity unconditionally?"
"No. If you sell it mid-term, you get back the remaining profit after repaying the bank. More accurately, since you've already sold the bond, you receive that profit when settling the repurchase agreement."
"I see."
Then I guess she now understands the basics of repos.
"Alright, shall we move on to some slightly more advanced content?"
"There's more? It's way more complicated than I thought."
"Can't be helped. This is the most fundamental skeleton of how financial markets operate. If you don't know this, you really won't understand anything."
If you don't understand repos, you can't understand the LTCM crisis, the IMF foreign exchange crisis, or the Great Recession.
Don't they often talk about it in Korea?
How merchant banks borrowed short-term bonds and lent them out as long-term bonds.
That's repo.
And you need to understand why they did such a foolish thing and where the problems arose to comprehend modern financial crises.
"We pledged $10 million worth of bonds to the bank. Based on that, we're calling it $300 million worth of U.S. Treasuries."
"I know that now."
"Then, does the bank take those bonds and give us money?"
"...Huh?"
Banks don't have money springing from a fountain, and they can't lend unlimited money just because they received U.S. Treasuries as collateral.
"The bank sells the U.S. Treasuries we pledged—more accurately, transferred ownership of with a promise to buy back—via repo."
"They can sell that?"
"The ownership is with the bank."
"Huh...?"
"That's called a re-repo."
"So... we sell to the bank via repo, and the bank sells it again via repo?"
"Exactly."
"Then isn't the bank just a broker?"
"That's also correct."
It is essentially a brokerage business.
They borrow money and pass it on to us.
"That's strange."
"In what way?"
"How does the bank make money? Do they get a commission when they do a repo?"
"Good question. That's what I was about to say."
I said while patting A-ra's head.
"There's something called the interbank market."
"Interbank?"
"It's like a wholesale market between banks."
"I see there is such a thing."
"The participants aren't strictly only banks, but you can think of them as mostly banks. Regardless of whether they are commercial banks or investment banks."
"Huh? Aren't commercial banks and investment banks separate?"
"For transactions between banks, it doesn't matter. Investment banks sell the received bonds via repo in the interbank market to get money, which they then pass on to us."
"Then ultimately, it's commercial bank money, so it's deposits, right?"
"Correct."
A-ra just blinked her eyes.
That's why they say if Wall Street collapses, the economy collapses.
The moment the repo market shakes, commercial banks shake along with it.
"And the interest rate in the interbank market is significantly lower than the general interest rate."
"Ah! The bank pockets the interest rate difference!"
Right.
They borrow at cheap bank-based rates and lend at LIBOR rates, creating a small profit margin in between.
That's one of the investment banks' main sources of income.
"And money market funds also participate in the interbank market."
"Money market funds?"
"MMFs."
"What are those?"
"Us."
"Huh?"
We are also a money market fund.
More precisely, members of a money market fund.