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Begun, The Repo War Has
Karl Denninger

There's been much strum and furor over the Repo transaction lockups that have occurred, and the insane amount of monetary injection that The Fed has taken on in response -- adding to its balance sheet at a torrid pace not seen since the days of QE.

They of course claim they're "not" committing QE.

They're lying.

But more to the point is why has the Repo market gone insane?

Nobody claims to know.

That's a lie; The Fed knows, precisely, why it's happening.

They're refusing to disclose the reason.

There are two plausible reasons for the lockup.

1. There is someone, a big someone, in a lot of trouble.  The most-likely candidate for that is Deutsche Bank.

2. The financial system is stuffed full of allegedly eligible collateral that in fact isn't eligible because it has a negative coupon on it and thus nobody in their right mind would accept it without a haircut representing the negative coupon times remaining duration.

Think about that one.  Let's say I have a 10yr bond with a negative 1% rate.  That means that after 10 years I get back 90% of my money, assuming it's a "zero" (that is, issued at par and redeemed at 90 cents.)  If you use that as repo collateral I will not give you 100 cents on the dollar; if the bond has 9 years remaining on its duration I will only post that as worth 91 cents.

Why?  Because if you default on the repo I get the bond.  But the bond isn't worth 100 cents, it's only worth 91, assuming I hold it to maturity, which I must be prepared to do because there is no guarantee of future market conditions (even tomorrow) and therefore what I might be able to sell it for in said market.  Indeed, my expectation is that I can only sell it for 91 cents on the dollar.

Now if the issuer continues to issue at greater negative rates then my NPV on that current bond may rise, but I have no assurance that will happen.  If they issue at less negative, or positive rates, the NPV on that bond will collapse.  But, if I hold it to maturity, I'm "guaranteed" (assuming the issuer exists, of course) that I will get 91 cents.

Therefore all I will count that as in a repo transaction is 91 cents on the dollar, and not a penny more -- and that assumes I believe the issuer (typically a sovereign government) will still be around.

The repo market is simply not set up to be able to deal with this and can't.  Effectively that 91 cents is a haircut on the collateral yet the repo market (which is fundamentally about balancing reserves between institutions due to ordinary flows of funds from one person or entity to another) goes whack if that starts being required, especially in a world where the required reserves are vanishingly small and thus institutions are free to "turn the crank" by re-hypothecating said securities to increase leverage.  If I'm forced to unwind the re-hypothecation it's entirely possible that the chain of hypothecation, in a negative-rate world, has negative real value in which case I'm effectively trying to divide by zero!

IF there are one or more institutions out there with significant trouble they're supposed to be identifiable because the proper place for them to go for funds is the Discount Window.  Those transactions are not hidden, however, so if you hit the window everyone knows you have a problem because those transactions are also at a "penalty rate" (that is, a bit more expensive) and nobody would pay that voluntarily.  Conspiring to hide said fact is a grave injustice.

But if the explanation is the second then it's far worse since governments continue to issue these negative rate securities and thus this problem will get worse and more wide-spread the more time goes on.  This in turn implies that the Fed will be "compelled" to increase its balance sheet without limit and since the US is not (at present) issuing negative rate debt it means The Fed is, from an economics standpoint, monetizing foreign government deficits!

That's illegal, incidentally, and if The Fed is doing that then we are merely a point of recognition away from the entire edifice of same collapsing, since neither The Fed or the Federal Government has any obligation to make said foreign debt "money good" -- and the people of this nation have every right to insure that it does not do so by whatever means may be necessary.

Mr. Denninger, recent author of the book Leverage: How Cheap Money Will Destroy the World, is the former CEO of MCSNet, a regional Chicago area networking and Internet company that operated from 1987 to 1998. MCSNet was proud to offer several "firsts" in the Internet Service space, including integral customer-specified spam filtering for all customers and the first virtual web server available to the general public. Mr. Denninger's other accomplishments include the design and construction of regional and national IP-based networks and development of electronic conferencing software reaching back to the 1980s.

He has been a full-time trader since 1998, author of The Market Ticker, a daily market commentary, and operator of TickerForum, an online trading community, both since 2007.

Mr. Denninger received the 2008 Reed Irvine Accuracy In Media Award for Grassroots Journalism for his coverage of the 2008 market meltdown.




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