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Q2 hedge fund letters, conference, scoops etc
Imagine approaching a friend who you think is very wealthy and asking her to borrow $10,000 for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.
On Monday, September 16, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.
The plumbing of the banking system and financial markets
Interbank borrowing is the lubrication that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that they have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.
What follows is a definition of the funding instruments used in the interbank markets.
- Fed funds are uncollateralized interbank loans that are almost exclusively lent on an overnight basis. Except for a few exceptions, only banks can trade Fed funds.
- Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repos can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.
On September 16, overnight GC repo traded as high as 8%, almost 6% higher than the Fed funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”? Before the 16th, a premium of 25 to 50 basis points versus Fed ffunds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16th, many multiples of that premium were not enticing enough.
Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. Neither excuse is reasonable, as they were easily forecastable weeks in advance.
Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.
Read the full article here by Michael Lebowitz, Advisor Perspectives
