Slaying of the Big Bad Bear - Mini-Analysis - Part II of III

This is Part II of my mini-analysis and a continuation from Part I. Click on this for Part I

Examining how 'repo' market transactions work:

Let’s say Bank A (investment bank) wants to make money by participating in a transaction including any security (bonds, equities, derivatives, etc). There is a series of transactions it would do to invest the security. Let’s say the amount it wants to invest is $100. And let’s say it wants to invest in Treasury bonds. The transaction sequence would be:

Transaction 1: Borrow $100 from Bank B. Tell Bank B it has $X in cash reserves as collateral.
Transaction 2: Buy Treasury Bonds for $100 from a Firm Y.
Transaction 3: Lend the $100 worth in bonds (not cash) to Bank C. Bank C sends $100 in cash as collateral.
Transaction 4: Use this $100 from Bank C as collateral to borrow $100 worth of Treasury Bonds (these bonds are different from those bought in Transaction 2).
Transaction 5: Sell bonds borrowed in Transaction 4 as a short (buy high, sell low).
Transaction 6: Sell bonds bought in Transaction 2 (they are with Bank C but can be sent back) long (buy low sell high).

Following so far? In effect the firm would make money if there is a difference in value of Bonds shorted and Bonds sold long. But the key point to remember is that Bank A has not used even a single $ of it’s own! Remember Transaction 1 began with Bank A borrowing $100 from Bank B. This $100 made it’s way around in the form of cash and bonds. But it was not Bank A’s to begin with.

Transaction 3 is what is known as the ‘repo’ market transaction. In effect Bank C is sending $100 to Bank A because it knows that the $100 worth of Treasury Bonds it is getting in return are valuable (since they are guaranteed by the US Treasury). Now Imagine if instead of these being Treasury Bonds, they are some of these Mortgage Backed Bonds (MBBs). By now it is common knowledge that these MBBs are not as valuable. Far being of any value everyone on the Street wants to avoid them like Plague!

So Bank C does not want any part of them and does not accept them as collateral. Uh oh! Bank A is now in trouble.

Continued in Part III.