Repos; the good author of financial crisis.
Repos, also known as repurchase agreement or RP is a form of short term borrowing mainly in government securities where dealer or holder of government securities sells to a lender and agrees to repurchase them at an agreed future and price.
The dealer sells the underlying security to investors and buys them back shortly afterward, usually the following day, at a slightly higher price i.e A will in the near date (tn) sell a specified security (S) at an agreed price (Pn) to B. A will then repurchase S in the far date tf from B at a price pf which is already pre-agreed on the deal date. Pf is expected to be greater than pn
The repo rate which is an annualized interest rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds.
The repo market is a significant portion of the money market. The federal is a major purchaser of repos providing needed liquidity for traders of short term money market instrument. There is a large repo market in the US and Europe.
The assets used as collateral should be free of credit and liquidity risks and exhibit minimal correlation with the credit risk of the collateral provided. The market value of the collateral should be certain so as to be easily sold for a predictable value. The repo market has been viewed as a potential cause of financial instability since the 2007 to 2009 financial crisis (Copeland et al., 2014)
The financial panic of 2007-8 stemmed from a run on the repurchase or repo market, the primary source of funds for the securitized banking system rather than a run on monetary deposits as in earlier banking panics (Gorton and Metrick)
Hedge funds are a real worry for the repo market because they never know when they are going to need a lot of cash quickly to cover a bad investment. These funds try to outperform the market by using risky derivatives and options, such as short-selling a stock. When their investments go the wrong way, and they can’t get enough cash to quickly cover them. They suffered huge losses that can take the market down with them. An example of what can happen is the October 2014 flash crash when the yield on the 10-year treasury note plummeted in just a few minutes.
The 2008 financial crisis is the worst economic disaster since the great depression of 1929. It occurred despite federal reserve and treasury department efforts to prevent it. The first signs of the financial crisis occurred in 2007. Banks panicked when they realized they will have to absorb the losses, they stopped lending to each other. As a result, interbank borrowing cost, Libor rose.