Fed’s Repo Rescue Leaves Many Searching for Answers

A spike Tuesday in short-term funding costs threw a spotlight on a market that has been a sore subject for bankers, investors and regulators alike since the 2008 financial crisis.Borrowers in the market for repurchase, or repo, agreements paid as much as 10% in morning trading, versus recent rates of just over 2%. The surge spurred the Federal Reserve Bank of New York to pour billions of dollars into the financial system to bring rates back down.Banks and brokerages use repo contracts to borrow short-term cash by selling a security, like a mortgage or a Treasury bond, and promising to buy it back in the future at a slightly higher price. Asset managers get a safe place to put money and (usually) earn a slight return.

But Tuesday’s rate spike came after a month of unusually volatile trading in the repo market and confronted some financial firms with difficult choices.

Ray Remy,

co-head of fixed income in New York at Daiwa Capital Markets America Inc.—one of 24 so-called primary dealers that can directly trade with the Federal Reserve—said he faced a decision early Tuesday whether to pay an interest rate above 7% for cash he needed for his bond-trading portfolio. Mr. Remy said he “took a deep breath” and didn’t borrow the money, hoping repo rates would fall. Borrowing at higher rates has “a huge, huge effect” on the profitability of large broker dealers, he said. Patience proved wise, as rates fell back near 2% shortly after the Fed’s action. Mr. Remy breathed a sigh of relief. “We kind of got lucky today,” he said. “The Fed came in.” As in any market, one side’s pain is another’s opportunity. Two government-backed financial giants,

Fannie Mae

and the Federal Home Loan Banks, both stepped up their repo lending at higher rates on Tuesday, according to people familiar with the matter. The home-loan banks, a network of government-backed lenders, were offering to lend overnight at 4% Tuesday morning, twice the recent going rate. When the repo market is running smoothly, it barely registers beyond a small group of dedicated traders and funding specialists. But a jolt like the one seen Tuesday raises concerns among bank executives, who count on repo to keep the lights on overnight, and regulators in Washington who rely on it to grease the skids of the financial system. Market participants on Tuesday were mostly at a loss to explain the magnitude of the spike. Most cited a confluence of unrelated factors that in isolation would pose no huge threat but combined to roil the market. Corporations paid their quarterly taxes, and the government collected payment for Treasury bills it sold to dealers last week. Both sucked billions of dollars out of banks and money-market funds, which created a pinch in available short-term funding. The Fed’s intervention Tuesday made more cash available to those seeking to borrow, normalizing rates.

The Federal Reserve Bank of New York poured billions into the banking system Tuesday.


brendan mcdermid/Reuters

The repo market played a central role in the financial crisis, when it froze as investors questioned the safety of the securities being lent. The collapse of short-term lending was later regarded as one of the first milestones of the crisis, signaling that investors no longer trusted large banks as mortgage-related securities losses mounted. So far there are no signs that sort of trust is at issue. Indeed, post-2008 regulations made it more expensive for banks to get involved in repo, further denting a market that relies on these institutions to act as middlemen. Traders and portfolio managers said the tighter rules have played a role in making markets including repo and other short-term arenas more difficult to trade in. Since the crisis, banks have shifted to more stable sources of funding that are locked down for longer periods—a response to concerns that short-term borrowing exposed lenders to risks that if realized could threaten to hamstring the economy. They raised deposits and pared back trading activity.

Goldman Sachs Group

got 21% of its funding from overnight secured borrowings last year, down from one-third in 2014. It had $70 billion of repo borrowings as of June 30, down from $160 billion in 2007. In fact, big banks lend more than they borrow in repo agreements, which have proven to be handy places to park the cash that Washington has required banks to hold since the crisis. Among the bigger uses of repo are nonbank brokerages, which don’t have access to cheap retail deposits.

Jefferies Financial Group

for example, funds nearly one-fifth of its $48 billion balance sheet through overnight secured borrowing, according to its most recent quarterly filings. Jefferies didn’t immediately return a request for comment. For those active in repo, the uncertainty is weighing on sentiment and will likely continue to do so until investors and bankers feel they have greater clarity. The Fed’s move Tuesday was welcome, traders said, but many were left wondering about the potential policy considerations. The New York Fed said late Tuesday it would repeat its $75 billion repurchase Wednesday morning, but many in the market were looking beyond that decision. “The market will be waiting to see if the Fed makes this a more permanent part of the playbook,” said

Beth Hammack,

Goldman’s treasurer. —Ben Eisen contributed to this article. Write to Liz Hoffman at liz.hoffman@wsj.com and Sam Goldfarb at sam.goldfarb@wsj.com

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