Last month the repo market, where banks borrow from each other and are supposed to pay interest on their overnight loans based on the fed funds rate set by the Federal Reserve, kind of, sort of, blew up.
Despite the fed funds rate, actually it’s now a “band,” having just been lowered by the Fed to 1.75%-2.00% some banks had to pay as much as 9% to borrow overnight in the fed funds market.
That’s what I call blowing up.
Here’s what the Fed said happened, what really happened, what it says about the Federal Reserve’s control over America and how it’s all going to affect the economy and your financial future…
Here’s the Low Down on Repos and Fed Funds
Repos, short for repurchase agreements, are loans mostly banks, but also broker-dealers and other commercial entities public and private, make to each other.
Most repos are overnight loans, though they can be “term” loans for days, a week, 14-days, or longer.
They are called repurchase agreements because a bank that wants or needs to borrow short-term money from another bank hypothecates (gives as collateral) U.S. Treasuries it holds on its balance sheet against the money it borrows. When the term of the loan is up, the bank that borrowed money repurchases its hypothecated Treasuries and pays a little extra to buy its collateral back. The amount it pays up is interest.
The interest rate on repos is usually based on the fed funds rate which the Federal Reserve determines.
Since the Fed just cut the fed funds target band to 1.75% – 2.00%, the interest on repos should be somewhere in the middle of that band, approximately 1.875%. The middle of the fed funds band is called the Effective Fed Funds Rate, or EFFR.
Repos are just overnight and term loans made within what’s called the fed funds market. The Federal Reserve determines interest rates paid in the fed funds market by targeting the actual fed funds rate.
When we hear the Fed is cutting interest rates, or raising them, it’s the fed funds rate they’re cutting or raising. Since the fed funds rate is the rate banks borrow at overnight from each other, it’s the “base rate” all other interest rates on other loans are based on.
At least that’s the way it’s supposed to work.
What Banks Are Missing and Hiding from You
But it sure didn’t work that way last week and isn’t working that way now.
Contrary to popular belief the Fed doesn’t just say what the fed funds rate or band is and banks just borrow from each other at that rate, or within the band, or exactly at the EFFR.
Supply and demand for cash determines what rates banks actually pay each other.
If banks start borrowing from each other at rates higher or lower than the fed funds target rate, the Fed, through its Federal Reserve Bank of New York conducts “open market operations” to get the rate in line with their targets.
Open market operations are simply the Fed itself conducting repos and reverse-repos with banks.
If the Fed does repos with banks, it’s lending them cash and taking Treasuries as collateral. If banks have more cash to lend, including to each other, the fed funds rate usually comes down.
If the Fed does reverse-repos with banks, it’s borrowing cash from the banks and giving them Treasuries as collateral. Taking money out of banks leaves them with less money to lend, if they have less money to lend to each other they charge more interest, and that raises the fed funds rate.
At least that’s the way it used to work.