What is a Repo Squeeze?

In November, The Fed called in the primary dealers of government securities for a talk because of concerns that they had been engaging in a type of activity known as a "repo squeeze". What exactly is a repo squeeze?

If you want a thorough answer to this question I recommend the following article from Mr. Mark Fisher of the Atlanta Fed: http://www.frbatlanta.org/filelegacydocs/fisher_2q02.pdf

If you want a quick and dirty answer, here is my attempt.

A repo squeeze is an attempt by one of the primary dealers to reap rewards by exploiting the periodic scarcity of a certain security: the so-called "on the run" T-Note.

The on-the-run T/Note is the most recently issued T/Note--the last one to be auctioned by the Fed.

The on-the-run T/Note is considered the most liquid security in the world, so it is often used as a hedge or source of funding. Dealers who have a short or long position in any treasury will often hedge this position by taking an offsetting position in the on-the-run T/Note. They will use repos or reverse repos to fund these positions.

A repo can be seen as a way of funding a long position by raising cash. You "repo out" the bonds you are long and get cash collateral in return. When you close the repo, you return the cash collateral + interest and get back your bonds. A reverse repo can be seen as a way of funding a short position by raising bonds: you "reverse in" the bonds, and pay out cash in return. When you close the reverse you return the bonds and get back your cash + interest.

The tricky part has to do with the fact that the on-the-run Note is often in high demand. Those who are willing to repo it out are awarded a premium in the form of a spread. These bonds are said to be "specials" That is to say, when you close the repo you will have to pay a reduced interest rate on the cash collateral. There is a simple opportunity to earn a profit here, by investing the cash at a higher rate than the reduced rate you will have to pay.

So where does the squeeze come in? As noted by James Clouse of the US Dept of the Treasury, the repo squeeze can be "an exercise in monopoly pricing". If you have a sizeable portion of on-the-run treasuries that are special, you can make money by repoing them out. But in certain cases, you can make even more money by holding back some portion of your sizeable position, therefore creating a scarcity of the on-the-run note, and making the position that you repo out even more special.

You can still fund your entire long position by doing a "tri-party repo" on the portion that you decide to hold back. In a tri-party repo, the bonds that you repo out are parked at a tri-party custodian account (usually BONY or JP Morgan Chase). You will have to pay the General Collateral rate on this repo (therefore no simple profit-making opportunity on this position), but the scarcity that you thus create will make the portion you do repo out even more profitable.

Why does the Fed care about this? Quite simply, when primary dealers squeeze an issue, investors have a hard time getting a hold of it, and trades fail.

The Fed is afraid of any practice which may cause the government securities market to seem less attractive to investors. At the present time the US government has issued debt over $8 trillion (i.e., the national debt). Because US Government obligations (mostly T/Notes) are generally regarded as the most liquid and safe financial instruments in the world, the government has a low cost of borrowing. Anything that undermines this reputation has the potential to increase the government's cost of borrowing.

So the Fed takes the possibility of repo squeezes very seriously.