Had a very interesting call with a correspondent this morning about the European Repo Market.
Most writing on bond markets treats bonds as if they are a savings vehicle and that the pricing is determined by how risky savers think the loan the bond represents is.
I have struggled over the past 4 years or so to determine whether this model of the world was only partially wrong or completely wrong. The reason is that the marginal bond does not serve primarily as an investment vehicle but as collateral for repurchase agreements or Repos.
What really matters is not the probability of default but the time path of the probability of default and the correlation of the probability of default to other instruments. If I have a bond A whose default probability is concentrated in the out years and is inversely correlated to the default probability of other assets then A is quite valuable as a liquidity hedge because when *stuff* hits the fan I know I will still be able to Repo my bond for short term cash, which can have very high value.
If I have a bond B that has a more uniform default probability and that probability is correlated with other bonds, then bond A can be more valuable than bond B even if the hold-to-maturity value of bond B is greater under all possible states of nature.
This is because in a crisis bond A can be repo-ed for short term cash with very little haircut, while bond B will have to be sold. Thus at the very point in time where money is expensive, bond A gets me money more cheaply than bond B. This is potentially more important than the hold-to-maturity value of the bond – under all state of nature.
I emphasize the later point because I am not merely suggesting that Bond A pays off in a world where my marginal utility of income is higher. I am suggesting that because Bond A is unlikely to default during the crisis event – even if it will in this world line – means that it retains its collateral status during the crisis and therefore allows me to extract cash when cash is expensive.
All of this is to say that the Repo market is key to understanding the bond market.
Here is the problem though – Bond A’s are floating out there in the world trading at extremely high yields. They are Sovereign Debt from Eurozone members.
This lead me to believe that something is wrong with the European Repo market. I called a student of this issue, who can identify herself if she wishes, on this only to find out that not only was she confused but so seemingly is everyone else. This includes the Eurosystem expert – apparently there is only one – on the state of the entire Eurosystem Repo market.
So no one knows exactly what’s going on here.
Some odd key facts though:
- German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate. I tell my students that this can’t happen. But, it is happening.
- Auctions for Sovereign debt are not only over-subscribed but more over-subscribed as the yields rise. Implying that the appetite for debt increases as the yield does. This makes sense if you are planning to Repo the bond. What doesn’t make sense is why this doesn’t drive down the actual yield
- Generally speaking there is enormous divergence in at the short end of Sovereign Debt curve and its not clear what theory of the world supports this.
9 comments
Comments feed for this article
Tuesday ~ November 29th, 2011 at 9:55 am
Phil Koop
You are going way over the top by thinking of bonds as exclusively repo instruments – too much of a good thing. Remember, from the outside, the repo market is just a banking system used by agents not eligible for deposit insurance. Also, I think you are exaggerating with this “nobody knows” stuff. Here is a quite intelligible piece in the public domain: http://ftalphaville.ft.com/blog/2011/11/28/767721/the-german-bond-market-is-all-about-buy-and-hold/
Tuesday ~ November 29th, 2011 at 11:38 am
Eurozone puzzles from Karl Smith — Marginal Revolution
[...] by Tyler Cowen on November 29, 2011 at 10:33 am in Economics | Permalink Some odd key facts though: [...]
Tuesday ~ November 29th, 2011 at 12:00 pm
Y. Alekseyev (@yalekseyev)
This may be taking it too far, but is there a possibility that there is a redenomination trade happening? Witness negative repo rates: why would anyone want to hold onto bunds as collateral so bad (and why would anyone want them so bad) that they’d be willing to pay money for the privilege of holding bunds OVER cash.
In what (liquidity constrained) world is cash less valuable than a bond with a negative yield? The one such world I can think of is a world in which there is a non-zero chance of said cash ceasing to be the means of legal tender (and people being uncertain as to how it will be redenominated) and a corresponding probability of said bond being re-denominated in a currency that is expected to appreciate.
For, say, an Italian bank, the calculus goes like this: if I hold Euros and Euro breaks up, my Euros will become Liras and I go bust, BUT if I hold German bunds, I will get paid in Deutsche Mark and I might just survive. Ergo, I better get a hold of some German bunds through the repo market even if I have to pay for it.
Thoughts?
Tuesday ~ November 29th, 2011 at 10:43 pm
sek smith
just one: in this case, people would try to buy bunds but borrow Italians to subsequently discount them with ECB. If you go bak to Lira, tough lack for your creditor.
But of course this would lead to very high demand of It in the secondary market and of bunds in the primary and now the tide is turning…
Tuesday ~ November 29th, 2011 at 1:27 pm
123 TMDB
“German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate. I tell my students that this can’t happen. But, it is happening.”
Non-banks cannot access the deposit facility at the ECB directly. Intermediation via commercial banks is too risky. This explains the anomaly.
Tuesday ~ November 29th, 2011 at 1:45 pm
Foster Boondoggle
Alekseyev, I think you have it backwards. Repo goes negative when there is excess demand to borrow the physical bond, typically so it can be shorted, the opposite of the scenario you describe. Repo doesn’t seem like a good strategy for someone who wants to own the physical bond, because they’ve already agreed to sell it back to the original owner tomorrow (or in a week or a month). An Italian bank that wants bunds would just buy them, and if repo is negative they can get some extra benefit by repoing them out, getting cash at negative interest and investing the cash elsewhere.
Tuesday ~ November 29th, 2011 at 5:38 pm
Axel
“German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate. I tell my students that this can’t happen. But, it is happening”
TMDB basically says that bund has become the deposit facility of non banks. And if you want to have bunds for risk aversion purpose, you don’t want to lend your inventory, to be able to access cash when/if needed.
It might as well be a typical short squeeze even if i doubt anyone really colludes to hoard bund and refuse to lend them in repo.
As far as auctions are concerned, I wouldn’t be surprised that when yield get higher, the governement begin to organize auctions in order to avoid failure which would trigger outright bail out/default. I mean that I doubt Italy and Spain laucn auctions without a strong cooperation with national banks which anyway know that 1) they will be able to extract cash ith these bonds from ECB and 2) in any break up/default scenario they would anyway be capitalized/funded along with the sovereign (and their shares would be worth 0 anyway). They have Strong incentive to coordinate at least for auctions. Secondary markets is a different matter obviously. Just an assumption….
Tuesday ~ November 29th, 2011 at 11:47 pm
sek smith
Certainly. But see
http://www.cindeurella.wordpress.com//2010/11/24/circular-financing-scum/
Wednesday ~ November 30th, 2011 at 8:38 am
Policy options for the Euro area « John Barrdear
[...] to the banking system, while currently large, is not nearly large enough. The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this. I currently have no opinion on whether this ought to be in the [...]