Repurchase agreements are lending agreements between borrowers and lenders. The borrower gets MONEY by entering into an agreement in which he or she sells securities that he/she owns and simultaneously agrees to repurchase them at a specific time and price. Since the repurchase is for a specific time and price, the RISK of ownership in fact continues to rest on the borrower. In other words, if the security’s price should fall, it hurts the borrower and not the lender, since the borrower has to buy it back at the end of the loan at the agreed price. The contrary is also true. If the security goes up in value during the time of the loan, the benefits of the increase falls on the borrower, since he or she is going to buy it back at the specific price. Since this ownership risk continues to rest on the borrower, the transaction is properly thought of as a borrowing/lending arrangement instead of a security sale. The lender can feel better about the loan, since the collateral is actually owned by the lender. The difference between repurchase agreements and reverse repurchase agreements is only a matter of perspective. The case described above is from the borrower’s perspective. The borrower sells the stock and agrees to repurchase it, so it is called a repurchase agreement. A reverse repurchase agreement is when someone has some money he or she would like to lend and buy stock with a simultaneous agreement to sell the stock back to the original owner/borrower for an agreed price and on an agreed date. The correct term to use depends on who initiated the arrangement. If the borrower initiated the agreement, it is a repurchase agreement. If the lender initiated the agreement, it is a reverse repurchase agreement. These repurchase agreements (often called “repos” or “RPs”) are usually for very short periods of time—maybe just overnight or for a couple of days. A long-term RP may last a few months. As explained above, the borrower still maintains the risk of ownership, but during the time of the RP agreement, the borrower has lost control over the security. Thus, if the price should be falling, the borrower is losing money and is not able to do anything about it, such as sell the stock until it is redeemed from the lender. For this reason RPs make sense for only a short period of time. In many cases the RP CONTRACT is organized using government and other low-risk securities. This reduces the lender’s risk of the loan’s collateral falling below the amount loaned. Often the lenders require the underlying security collateral to be greater than the loan. This excess of collateral over the amount loaned is humorously named “a haircut.” A haircut protects the lender if security price falls during the time of the agreement. The repo contracts usually involve large amounts of money, which are often arranged in blocks of $10 million and are usually overnight contracts. The agreement normally specifies a certain interest rate paid by the borrower when the stocks are repurchased. Any appreciation in the stock or security payments such as DIVIDENDs paid during the loan reverts to the borrower. Since the amounts involved are fairly large, usually institutional investors (instead of individuals) are involved in repurchase agreements. These INVESTMENTs are subject to some restrictions regarding to the risk investors can assume. For example, a city government may restrict its treasurer to only low-risk investments such as treasury BONDS issued by the U.S. government. However, buying these bonds as an outright purchase may involve a relatively long-term commitment of the city’s funds. The treasurer can lend money in the repurchase agreements and only involve the city’s money for a short period of time. The treasurer can specifically design the repos’ maturities to fit his overall cash-flow needs. Interestingly, the FEDERAL RESERVE SYSTEM (the Fed) uses repurchase agreements as one of its OPEN-MARKET OPERATIONS. If it desires to exert upward pressure on INTEREST RATES, the Fed enters into repurchase agreements as the borrower. If it wants to exert downward pressure on interest rates, it enters into repurchase agreements as the lender. The duration of the agreement may be for just a night but is often for a couple of weeks. Any effect on the interest rate that is accomplished when the Fed enters into one of these agreements is reversed when the agreement matures. It is not unusual for the Fed to enter into as much as $6 billion of these agreements a day. Mack Tennyson