Why Repo Exists
By Arnold Kling
Nick Rowe asks the question. My answer is based on Marcia Stigum’s Money Market, a book that more economists need to read.
Securities dealers are dealers, sort of like auto dealers. If you go to an auto dealer, you expect to find cars on the lot to buy. The dealer does not have the capital to have $1 million tied up in inventory. So the dealer takes out a loan from the bank, using the inventory of cars as collateral.
Now think of a securities dealer. It has an inventory of Treasury securities. It finances them with a loan, using the securities as collateral. If firm A lends to dealer B on a one-day repo, firm A actually has ownership of the security for the day. Dealer B buys the security back from dealer A one day later, at a higher price. The price difference represents the repo loan rate.
Now, at some point, if lots of dealers are financing portfolios of 10-year bonds with one-week repo loans, a fall in the value of 10-year bonds is going to cause some serious problems. Until something like that happens, though, you don’t know whether there is too much repo out there. I wish Gary Gorton, who is in love with repo, would at least admit the possibility that there is such a thing as too much of it.