Repo Programs vs. Wholesale Advances: Be Sure You’re Comparing Apples with Apples

The Repo Market as a Potential Source of Funding

Among the wholesale liquidity tools available to Seattle Bank members are Seattle Bank advances, standard and structured repo programs, Fed funds lines, and brokered deposits.

In its simplest form, a repurchase agreement, or “repo,” represents a transaction in which a borrower lends assets to a counterparty in exchange for funds. Assets typically consist of U.S. Treasuries, agencies, or mortgage-backed securities. The lending counterparty purchases the securities, and the borrower agrees to repurchase at a future point in time. At that future point in time, the lender returns the securities to the borrower, and the borrower remits interest and principal to the lender.

In a typical repo transaction, the lender will require a maintenance margin that represents between 102% and 105% of the loan amount. In the event that the price of the underlying asset declines, the margin must be replenished.

In addition to the standard repo programs, which largely consist of overnight maturities, there is also liquid market for term repo that may be set off of both fixed-rate and floating-rate indices. Structured repo programs, which emulate many of the structured advance characteristics offered by the Seattle Bank, have also evolved. These structures would include floating-to-fixed rate convertible structures, cancelable or “returnable” repo, and floating-rate repo with embedded interest rate caps.

Repo rates are based upon the following factors:

  • Quality of the Collateral: Treasuries are higher in credit quality and, therefore, carry lower repo rates than mortgage-backed securities.
  • Term: Rates correlate with corresponding maturity points on the yield curve.
  • Collateral Availability: If specific collateral is difficult to procure, the repo rate is typically lower. Why? Because the party that requires the collateral would be willing to lend funds at a lower rate in order to obtain it.

Comparing Apples with Apples

A direct comparison between a Seattle Bank advance and a repurchase agreement may be misleading. Consider the following example to understand why.

Let’s assume that you are considering obtaining a three-year Seattle Bank advance with a rate of 5.37%. As an alternative, you could obtain term funds from the repo market a rate of 5.32%. Keep in mind that the securities that you have repo’d are marked-to-market on a daily basis and must be replenished if they fall below a pre-specified threshold.

At first blush, you might be inclined to go with the term repo structure because it appears to offer a five-basis-point advantage. But, you remember that repo agreements require that you use a portion of your marketable securities portfolio as collateral. That comes at a cost. In funding the term repo, the counterparty, or dealer, would hedge the transaction by pledging the collateral you provide to access his own funding. He might, for example, swap a three-month term repo into a fixed rate. Depending upon how the dealer finances the position, using your collateral, he has the ability to fund his balance sheet on the order of five basis points below Fed funds in the overnight repo market, and on the order of 15 basis points in the three-month term repo market. His opportunity comes at your expense! Assuming that the dealer has been financing the three-year obligation by rolling your collateral every three months with an interest rate swap, he’s using 15 basis points of your money. As such, you might conclude that the opportunity cost of the foregone collateral makes the Seattle Bank advance 10 basis points cheaper than the repo. That’s assuming your collateral hasn’t gone “on special.” What’s so special about collateral going “on special”? If dealers are taking short positions on specific issues, holders of that collateral may use it to borrow at extremely low rates (below 1% in certain instances).

Cost Component Three-year Advance Three-year Repurchase Agreement
Funding Rate 5.37% 5.32%
Opportunity Cost of Foregoing Marketable Securities Collateral -0- 0.15%
Combined Cost Components 5.37% 5.47%

Here’s another angle aimed at deriving an apples-with-apples comparison. Assume that you’re facing two funding choices:

  1. Borrowing in the wholesale advance market, pledging single-family residential whole loans as collateral and foregoing the payment difference that would be made in the form of a guarantee fee for the additional liquidity of a marketable security. (The guarantee fee associated with a payment to FNMA or FHLMC for securitization of a whole loan into a mortgage-backed security could be assumed at 20 basis points.)
  2. Turning those whole loans into mortgage-backed securities, absorbing the additional incremental 20 basis points in cost, and applying those mortgage-backed securities as collateral in obtaining funding in the repo markets.

At the margin, by borrowing off of your non-“repo-able” whole loans, you are saving something on the order to 20 basis points that you have gained from not having securitized the loans into eligible mortgage-backed securities.

There are also qualitative reasons that you might consider in eschewing repo funding. Your marketable securities represent a primary source of potential liquidity on your balance sheet. Why not first tap into the whole loan collateral that you have within your blanket lien at the Seattle Bank? Here, the opportunity cost of borrowing against whole loan collateral is minimal, in that a repurchase agreement market for this type of collateral is limited, or doesn’t exist. You also don’t have the operational costs associated with constant valuation benchmarking and maintenance margin fulfillment requirements that are associated with the repo markets.

In the capital markets, the sticker price often doesn’t tell the whole story. In the case of comparing repurchase agreements with other potential sources of wholesale funding, don’t compare costs at face value!