The legal construction of this, of this thing is like a collateralized loan. But it's much more symmetric. Okay? It's much more symmetric than a normal loan, normal collateralized loan if you think about it. You know, the, the, the collateralized that you and I are most familiar with is the house mortgage, okay? So, I, the, the, the bank, if I default on my loan, okay, they have the ra, they have the right, they have claim to my house. They can take it. They can sell it. And use it to recoup the, part of the loan. all of the loan hopefully if the value of the house is enough. but it's not easy for them to do it. They don't actually, they're not in possession of it. They have to run through foreclosure. They have to do all this stuff and it takes months and it takes legal fees and it's clear that they don't really intend to do that. That's not the nature of this. Okay, whereas this, these are overnight loans for $10 million, okay? And nobody wants there to be any, any question about this, that you, you own it. You, you're able to take that security. and not only do you own it, meaning if they don't repay, often you own it, you can [UNKNOWN], you can sell it to somebody. You know, they, you, they've given you this as security for the loan. You can sell it to somebody and trade it you know, all day long. All you are reliable, liable for, is returning it to them the next day when you, when you, when you promised to. You have the security, you can, you can trade with it. Just as the, on the other side, you have this money. And you can spend it. You can buy something else with it. You can, you can do whatever you want. So, it's much more symmetric than, than a standard, than a standard kind of loan. And who gives margin to who? Okay, because if you think of it, taking in a security okay as, as as collateral for a loan the danger of me holding the security is the value of the security will fall. The value of the security falls below the value of the loan. Then there's an incentive for him not to repay me. Okay. But the reverse is also the case on the other side. Okay? If the value of the security goes up, okay? It's in his advantage to say. To, to not return the security. To hold, to hold onto it, okay? So who gives margin to who? Stiggem, Stiggem raises this question. And she says, and I think it's an, it, this is an, a sort of interesting deep feature of this market. it is the person lending money who gets margin. It's the person lending money who gets margin. Not the person who's lending securities. it's the, this is part of the hierarchy of money and credit now. It's the, the money is the better asset. And they're the ones who can demand, who can demand collateral, and demand extra security. and so, what you see. Is this phenomenon of the haircut. That's the extra security. And the way, the best way to understand this. And now we're going to get really specific, okay? she gives an example, on page, 533. But I'm just going to write down the numbers here. She says, for example. A ten year treasury bond is the security we're going to talk about, and this treasury bond is trading, right now, at 100 29/32. That's how they used to quote these prices. We've moved to the decimal system, but the book is a little older Uh,129 30 seconds, so it's trading a bit above par. probably because the ten year interest rate is a little lower than the coupon on this bond. Okay, that why that, why that happens. So this is its core value in the market here is a 129 30 seconds. Okay. The person who has this bond wishes to offer it as collateral in order to borrow money overnight. Okay? How much money can they borrow? In her example she says the haircut is 2%. Okay? So that means the the your able to borrow, not 100 29/30 seconds, but a 99.228. You should do the math for me. Okay? So that's this minus 2%, okay? This is how much you could use that bond to borrow, there's a 2% haircut there. What that means is that if, if the, the bond falls in value by more than 2%, then there is no incentive to default, okay? But, but there's, but it's an overnight loan and these prices don't fluctuate necessarily that much. If they fluctuate more, the haircut's going to be bigger. You know, you know if you're talking about a mortgage backed security, it's not going to be a 2% haircut, it's going to be a 5% or a 10% or a 50% haircut. and in a crisis maybe they're not acceptable at all, okay? So the haircut is negotiated first. How much money will you lend and it has to do with the volatility of the price. You can see, and you can see why. So that's the first thing. And then the question is, what is the interest rate going to be? And so, and that's what we call the repo rate, and the repo rate is negotiated. And she says, it's 4.92 %, I think it was, 4.92%. That's an annualized rate. we're only, we're only going to be applying that rate to one day. It's an overnight, overnight repo. So what happens is, you borrow $99, or, or this is a million dollar bond, so this is $990,000, okay? And you repay what? Tomorrow. You repay the principle, 99.228 plus interest. And the, and the, the convention in the money market is, is this. That you, it's, it's a straight interest, not compound interest. So, it's 0.0492. Okay, times one over 360 because it's one day. It's, it's overnight. If it was three days that would be a three, okay, and if it was a week that would be a seven, okay. This is not like some of the interest rate formulas you, you're used to seeing where it would be compound, you'd be raising it to a power. Also note that they're treating the year as if it has 360 days in it. Okay? Even though it doesn't, okay? So these are just quoting conventions, okay? You can, you can understand that the market knows this and it can change this number to take account of the fact of this quoting convention. But it's a,it's a quoting convention that is since time in the memory I suppose and this can't be changed okay? This is how things reported in money markets. Now in money markets this sort of thing doesn't make that much difference. It makes just pennies, okay because it's really overnight. It's not very, very much interesting you're talking about here. So the difference between 360 and 365, the difference in compound interest. Is not, doesn't amount to, to more than the fourth decimal point, but it amounts to something and so you want to get this right if you're trading in this market. If you do this math, which I did myself, you come up, and I hope, I did it using my calculator, so I hope I punched in the numbers right, you come up with 99.228 137. So, almost the same. So, you borrow this much, and then the next day, you return this much. But if this is a million dollar bond, what you're talking about is $137.00. $137 of interest. So it costs you $137 to borrow a million dollars overnight, that's what the repo market is doing for you, okay? Notice how the haircuts Are another way of making heterogeneous collateral homogeneous. Saying, this one will give you a 2% haircut this one will give you a 10% haircut, we will apply the same repo rate to them all. Yes? >> Uh,when someone loans out money and their securities are earned. >> Mm-hm. >> Have to negotiate for a haircut, aren't they under the impression? I mean if they accept that security then they're taking a short position makes it easy then just sell it and then when they have to return the security they buy at a lower price. So why do they get, why do they necessarily get the margin when it should be implied that they're taking the short position and they can easily just sell it and buy it back if they needed to? >> Mm-hm, well that's the puzzle. >> That's the puzzle that she raises in the book. It just is never the case. It's never the case. It's the person who has money, who is the one who can demand margin. I mean, both sides can try, and in many swaps. Both sides put up margin. You know the, it's, it's, it's typical in, in swaps that both, that both sides have to put up margin. But in repo, no. It's, it's the side that is borrowing money, borrowing money that has to put up, that has to put up margin. To me, this tells you. That money that that that that the demand for for liquidity for borrowing money is what driving this. This is this is the short side of that market you know, that people are willing to pay up in order to get money, they are not willing to pay up in order to get collateral. So that's why the margin is this way.
