Repo is short for repurchase agreement. Wall Street firms (and hedge funds for that matter) hold billions and billions of fixed income securities. As we learned in the financial crisis, these securities are not paid for with a firm’s capital. Instead every dollar of capital in a Wall Street firm is leveraged into several dollars of securities. How is this possible you ask? Enter the repurchase agreement.
A repo is nothing more than a collateralized loan. On Wall Street this collateral is fixed income securities. (Note the same process goes on in the equity market, but is known as stock loan) The term of these loans can vary from overnight to 1year, with the most common being overnight. In its simplest form a real money account, such as a money market mutual fund, lends money to a Wall Street firm. In return, the Wall Street firm wires them securities. At the end of the loan, usually the next day, the mutual fund wires back the securities in exchange for their original loan amount plus interest. The interest rate in normal times is very close to the Fed Funds Target.
Repo desks carryout two functions: 1. Funding the firm’s position (as in the process described above) and 2. Covering the firms short positions. When a firm or customer is short a security they are still required to deliver said securities to the counterparty they sold these securities to. This creates distortions in supply and demand based on who holds what securities at any one time. This is the basis of the “specials market”. Specials is the borrowing and lending of specific securities. A general rule of thumb is the more people who are short or looking to short a security, the more in demand this security will be, and the lower the rate of interest required to use this security as collateral in a repo.
So for example if I am the holder of a current U.S. Treasury 10year note and I need to raise money to pay for this position, I will call a repo desk and ask for their bid on my position. They will quote me a bid, the rate of interest they are willing to accept for a loan based on using my position as collateral. This interest rate will be based on whether the firm needs to cover a short in the 10year note or what interest rate they expect they will have to pay if they turn around and relend the position into the market. It is important to note that in order to mitigate the credit risk of the counterparty that you are lending money to, it is normal to take in $1.02 of collateral for every $1 you lent out against it. In this way if you lent out $1 vs. a 10year note and the counterparty of the loan went out of business you had $1.02 of 10year notes that you could sell to recoup your loss. This extra $0.02 in securities is referred to as a haircut.
Now back to my story. So my first job on Wall Street was as a sales assistant on the repo desk. Our customers were both real money accounts, that we used to fund our firm’s positions, and hedge funds that were seeking to achieve leverage. When I first set foot onto the trading floor in the summer of 1999, I was overwhelmed. I had never heard of a repo or seen a bond trade. My experience with investing, like most people, was limited to mutual funds and equities. All that would quickly change.
Over the next 5months I quickly learned the ins and outs of being a sales assistant. My main responsibilities were helping cover the phones for my sales team, booking tickets, interacting with the traders to find out how we could help them, and occasionally speaking to clients if the rest of the sales team was occupied. There was one glaring exception. Under no circumstances was I to answer one Hedge Fund’s direct line. If the salesperson who covered them was off the desk, I was to let the phone ring and race around the floor to find them. This account was Phoenix Fixed Income Arbitrage.
In the winter of 1999 Phoenix Fixed Income Arbitrage were the darling of the repo market. With assets under management of $250 million and huge positions in U.S. treasuries, when they called in to do a trade it could make or break our trader’s day. The saleperson who covered them was treated like a rock star by the trading desk. The largest position that we had with them was in the current U.S. 10yr note which at the time was the 6% 8/15/09. For weeks we had been borrowing from them over $1billion in U.S. 10yr notes on an overnight basis. Meaning each day we were asked to lend them over $1billion for 1 day. The overnight loan would be secured by U.S. 10yr notes. For our head trader, every trading day revolved around setting up to do this trade. At the time we knew their total position in 10year notes was larger than $1billion, because every day when their trader Stephen Duthie called to roll his position with us it was obvious, based on the price action in the interdealer market, he had just done the same trade with someone else. So our head trader would vary his strategy between selling as many 10year notes overnight to the shorts as he could before be asking to bid Phoenix’s piece or buying all the 10year notes he could and cornering the market.
The gravy train ended rather abrupty on 1/5/00. The day started like any other. I went through my check list of beginning of the day tasks and helped answer phones. Slowly the morning dragged on until our head trader yelled over to our sales team to try and get Phoenix to lend us their 10year position now while rates were favorable. Our salesperson rang the direct line. No answer. This went on for several minutes. A few minutes later a back office person from Phoenix called to confirm the maturity of a trade with our salesperson (common practice for large term trades to ensure the correct money amounts were wired ). The trade was a repo transaction (us lending securities to Phoenix in exchange for cash) from several months ago that was supposedly ending that day for $3billion 10year notes. We of course knew of no such trade. Things were starting to get weird and there was still no answer from Stephen when our salesperson rang him. It wasn’t for another half hour, when a controller at Phoenix called, that the story came to light.
Apparently Phoenix Fixed Income was insolvent and had just realized a rogue trader, Stephen Duthie, who managed a $150million dollar fund, had cost the firm $125 million. Approximately 3months ago, Duthie, made a large “carry trade”. He had purchased $3billion 10year notes that had a 6% coupon from our firm in the outright market. He intended to lend them everyday in the repo market and pay interest rates of between 2-4%, depending on how special (how much demand there was in the repo market) they were trading. Thus generating “carry” of between 2-4% a year. Well 10year notes like any security don’t trade at the same price everyday. The price goes up and down based on market expectations of interest rate. Duthie was placing a massive bet on lower 10year yields and leveraging up his $150million dollar fund 20:1!
In order to both deceive the risk managers, who would have surely disallowed such a risky transaction, and to mitigate the mark to market swings he would take on such a position, he chose to book his outright purchase of the 10year notes as a 3month reverse repo (Phoenix borrowing $3billion 10year notes and lending us cash). Then each day he was booking several large repo transactions (Phoenix lending 10year notes and borrowing cash) with firms on The Street to cover his cash needs. Well sure enough at the end of 1999 the Federal Reserve started hiking interest rates from 4 ¾% to eventually 6 ½% by the end of 2000. Along the way 10year note yields skyrocketed in anticipation of permanently higher interest rates, from just below a 6% yield to over 6.60% by 1/5/00. Duthie’s massive bet was hemorrhaging.
Chart of closing 10year yields. Note the spike at the end of 1999.
On the morning of 1/5/00, the day his supposed $3billion reverse repo transaction ended, Stephen Duthie did not show up for work. He fled. Rumors flew that he had fled into the woods of Canada and not even his wife knew where he was. Thankfully we had taken “a haircut” on the trade. Meaning we had only lent Phoenix $1 for every $1.02 of securities they used as collateral. Also since each trade had been overnight, the value of the securities had changed each day and we had only lent the appropriate amount based on that day’s market value. When the fraud became apparent, Phoenix quickly began selling their outright position into the market. The weight of $3billion in 10year notes hitting the market quickly pushed yields even on higher on 10year notes, which increased the loss. Fortunately for us and the other repo counterparties on The Street, the 2% haircut had protected us from losses and Phoenix was able to repay all their loans. According to the U.S. Treasury website on 1/4/00 10year yields had closed at 6.49%. Due to Phoenix’s selling, the same security closed at 6.62% on 1/5/00. A massive one day move in yields.
For a great treatment of this scandal as it was reported in the press (minus the real details of how the money was lost), check out this article.
Just 5months in to my Wall Street career I witnessed how one man’s hubris could take down an entire firm. Unfortunately it would not be the last time I would see it. Interestingly enough, Phoenix ending up liquidating their 10year note position at the peak in yields. It marked the beginning of one of the longest bull markets in bonds that the market has ever seen. Duthie’s position had been too big and just a bit too early. As they say “Timing is Everything.”
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