The Repo Market Awaits

You can take comfort in the knowledge that this global mess we call a financial system is all about the banks. Successive Greek bailouts (not to mention Ireland and Portugal) were about protecting undercapitalised and essentially insolvent banks.

We’re not exactly breaking news here. But we feel we must continue to shout into the wind and maintain that this slow motion implosion of the global economy is all about the banks. Politicians may be our nominal leaders…but the bankers sustain the politicians. Therefore the bankers call the shots.

Central banks…commercial banks…they’re all complicit. After they stuffed debt down people’s throats for decades, the world threw up on them in 2008. This created a problem. The bankers were losing control. But like cornered rats, the banks fought back. They have survived and grown bigger, sinking their teeth into the real economy. The big players have completely commandeered the world’s resources for themselves.

If you think that’s overstating the issues, just give it time…you’ll see what we mean.

Because while you’re focusing on Greece or China or something else tangible, the real danger lies where you can’t see. It’s deep in the plumbing of the financial system…the repo market and derivatives. We’re convinced that the next blow-up will come from deep within the bowels of the financial system.

That’s because a prolonged zero interest rate policy of the world’s reserve currency retards the financial system. We made the point yesterday in our Sound Money. Sound Investments newsletter. Just as Einstein’s Theory of Relativity demonstrates that weird things happen as velocity approaches the speed of light, the financial system distorts as interest rates move towards zero.

The whole point of low interest rates is to push investors out of low risk assets and into ‘risk’ in the search for yield. Big money in search of yield AND liquidity migrate into the ‘money markets’. This is a cash-like asset class that invests in non-cash-like risk.

For example, in a search for yield (and to keep income above running costs) big US money market funds channel some of their investments into European bank debt. Hardly cash-like investing but that’s what zero-bound interest rates make you do.

But because of the risks (Europe’s banking system is under constant threat of a ‘run’ developing) these money market funds (MMF) are increasingly asking for security for their loans. The transaction takes the form of a repurchase agreement – a ‘repo’. That is, the MMF hands over cash to the bank and the bank gives the MMF $102 in US Treasuries. The treasuries are the security and the additional $2 is the discount rate applied. At the end of the term, the repo is unwound and the MMF makes 2%.

In this way, the bank can borrow at US government rates (it essentially rents the government credit rating), while the money market fund can earn slightly more than nothing by lending its funds out.

Here’s a chart from Fitch Ratings that shows the increased use of ‘repo’ by US MMFs.

increased use of 'repo' by US MMFs

If you can get your head around the mechanics of repo transactions, you can see why the demand for US treasuries and other high quality securities (like German bonds) is so high. In the money shuffling factory of the global banking system, more and more investors want security against their loans. And there are fewer and fewer assets that qualify as high quality security.

To keep the money flowing the banking system (or more accurately the shadow banking system) increasingly ‘rent’ government credit ratings. When that government paper is eventually discredited…the proverbial will hit the fan.

This is the disease of zero interest rates. It encourages an ‘all risk for little reward’ mentality. Because banks can no longer make good money from the ‘spread’ (borrowing at 3% and lending at 6%) they jack up their leverage and turn to speculation. The bank becomes a casino, assuming the role of both house and player.

The taking of risks over a prolonged period erodes credit quality. And governments, seduced by low interest rates, borrow too much…which eventually erodes their credit quality too.

The interest rate is an implied signal of credit worthiness. Driving interest rates down artificially implies low credit risk. In reality, it is completely the opposite. Central banks and their masters, the big commercial banks, are completely retarding the price signals that capitalism relies on to function properly.

When the US bond market eventually blows up, the repo market will blow up too. There will be absolute carnage. But thankfully, we’re probably a few years away from such a scenario. There will be other blow-ups before the US. Europe is first in line, Japan is next.


Greg Canavan
for Markets and Money

From the Archives…

The Physical Gold Market – From the Weak to the Strong
2012-05-18 – Greg Canavan

Why JP Morgan is Playing the Same Old Rigged Game
2012-05-17 – Eric Fry

Why Greece Can’t Afford to Stay in the Euro
2012-05-16 – Dan Denning

A Big Oops at JP Morgan!
2012-05-15 – Dan Amoss

Preparing For China’s Growth Slowdown With The ‘Energy Hub’ Portfolio
2012-04-14 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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