Repurchase Agreement Clarification?
Just a quick question on repurchase agreements.
I get the concept; Company A sells securities to Investor A in exchange for a cash loan, and then buys the securities back at a slightly higher price later.
I understand the incentive for why an investor would want to buy the securities, because they can earn interest on it and so make some money in a short period of time.
My question is, what's the incentive for a company to sell securities in the first place? Eveyerwhere I read said that it's a fast way for them to get money, but seeing as repurchase agreements are typically pretty short-term, how are they making any money or using the loan at all? It just seems like if they take the loan and invest it in something, they wouldn't get very far because they have to buy their securities back (at a higher rate too) essentially the next day.
repos are often used in cash and short term strategies...also sometimes for (as you mentioned) liquidity needs within a firm
Repos aren't really a way to earn money; they typically serve as an overnight source of financing. Because it's so short-term, the increased price at which they buy the securities back is negligible.
Firms roll over their debt, and the repo market is one of the most important ways they do it. After Lehman collapsed, there was a run on the repo market, and none of the banks could get financing as the liquidity was drying up.
This was actually the straw that broke Drexel Burnham's back--one weekend, the other big investment banks closed ranks and refused to provide repo lending to Milken's group. The bank didn't survive the weekend.
Wait, so do firms engage in repos to refinance a debt?
Not exclusively. It's one in a number of reasons. It can be used to refinance debt, but like Pfalzer and sntsnt said it's just a way to get cash when you need it. The uses of that cash can be whatever you want. You sometimes need cash right now and can't wait, so you go to money markets and repos is a way among others to get it.
I guess what's confusing me is that if firms use repos to get quick cash to use, how are they able to buy the securities back after a night then if they've already used the money from the repurchase agreement? I mean, clearly they entered into the agreement because they had no other way of getting money, but now they just suddenly have money to buy the securities back?
just think of repos as collateralized loans because thats what they are. For example I have one dollar and I use that dollar to buy a bond. But i want to lever up and buy more bonds. So I take the bond I have and pledge it as collateral to borrow another dollar. That transaction (where I send somebody a bond as collateral and they give me a short-term loan) is a repo. The interest I pay to get that short-term money is called the repo rate. If its an overnight repo then the next day you have to either do the repo trade again to finance the position, or you have to liquidate the position you bought with the money you borrowed.
^^Very good explanation.
Money markets desks fund most of the other desks at most firms through receiving cash and giving interest to companies overnight and repos. If the bank needs more financing O/N due to some investment banking deal or whatever else they sell off some collateral to borrow that money.
The short-term and money market are based overnight because the GE's of the world manage their real-time-cash needs day-to-day. The cash they have left over they invest O/N.
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