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Repurchase Agreements (Repo transactions) - YouTube
Channel: Khan Academy
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Let's say that you're in
desperate need of money and I
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have money to lend
to other people.
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So this is me and this
is my gold chain.
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So you come to me and say,
Sal, I need $10,000 for a
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kidney transplant.
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Can you lend me the money?
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I'm in desperate need.
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And I have $10,000.
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Sure, I'm willing to lend it
to you, but it's a tough
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economy and you never know where
that money's going to go
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and I don't know if you're going
to be able to keep your
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job after going through this
kidney surgery and all that.
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So I'm very careful with my
money so I want to make sure
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that you're good for it.
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So we think about it a little
bit and I say, hey, that watch
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you have on your wrist, that
looks pretty nice.
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You say, this watch?
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Let me draw the watch.
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And I say, yeah, that watch.
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You're like, this watch
I got from my
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great-great-grandfather and it's
actually worth-- I don't
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know-- maybe it's a diamond
studded Rolex of some sort and
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it's actually worth
$30,000, right?
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And I know that, clearly because
I've already become
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well acquainted with gold and
diamonds and things like that.
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So I say, I trust you and
you trust yourself.
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I'll lend you the $10,000, but
just so that we all know that
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everything's going to be fine,
why don't you just leave your
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great-grandfather's
watch with me?
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And when you pay back the
$10,000 with a low interest--
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let's say it's 10% a week-- when
you pay back the money,
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the principal, with the
interest, however long you
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borrow it, I'll give you
back your watch.
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You're like, I don't
know about that.
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First of all, 10% a week
sounds like a lot.
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I was like, well, don't you just
need it for the kidney
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transplant tomorrow and then you
can work a couple of weeks
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and then pay it back.
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10% a week's not bad-- and we
all know that that is because
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you compound that over the year
and it becomes some type
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of horrendous interest rate.
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But you're desperate.
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You need your kidney and I'm
like, look, you plan on paying
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me back, right?
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So you're going to get your
$30,000 watch back, so what's
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there to worry, right?
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So why don't you just leave this
with me as collateral?
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And you say, fine and you leave
your watch and you get
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your kidney transplant and then
you try to work really
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hard to pay it back,
but you never can
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and I keep your watch.
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And this is how the pawn process
essentially works.
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You've pawned your watch off to
me, but in a less kind of
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derisive way of talking about
it, you've given it as
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collateral for a loan.
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And I was willing to give you
the loan because I knew that
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if you couldn't pay it back, I
could keep this nice asset.
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And this happens all the
time in less shady
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parts of our economy.
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A bank will give you a loan and
they'll collateralize it
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by the house.
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If you can't pay the loan,
they keep the house.
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They want you to put a down
payment on the house so that
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even if the house devalues, they
still capture back most
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of their money.
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And so this is a pretty
straightforward
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collateralized loan.
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This is the collateral
you give me.
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I give you the loan.
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You pay it back.
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I give you back the
collateral.
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Now what if there was a reality
where I don't-- me as
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the lender, I don't even like
this notion of collateral and
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all of that.
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I actually want to make it
very clear that I have
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ownership of the collateral
when it happens, right?
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I don't want some Feds coming
in and saying, wow, whose
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watch is this that
you're holding?
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Where's the receipt for this?
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Where did you get it?
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Was it stolen from somebody?
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And it looks all shady and I
probably do have some side
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shady operations anyway so I
want to know that I own this
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watch in the event that
you don't come
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back to pay the loan.
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So instead, we could have done
this exact same transaction--
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so this is you again.
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This is me again.
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I'll draw that top hat
and the moustache.
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Those are my differentiating
characteristics, maybe the
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gold chain.
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And now what I can do is--
because I want ownership of
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that watch, what I'll do is I
will buy that watch from you.
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So you'll give the watch-- so
the watch will literally
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change hands.
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So I will buy the watch
from you for $10,000.
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But we'll also have
a side agreement.
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So far it's almost
identical, right?
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The only difference between this
and what we did before
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is, I'm actually selling
the money.
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I'm actually buying the
watch from you.
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This is a cash transaction.
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This wasn't a loan, strictly
speaking, but the same thing
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is happening, right?
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Up here you handed
me the watch and
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I handed you $10,000.
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Here, you handed me the watch
and I handed you $10,000.
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But what we'll add on to this
is an agreement that at some
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future date-- so this is now.
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We also going to have an
agreement-- and both of us are
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parties to this-- that in the
future, I will agree to sell
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and you will agree to buy this
watch for me for something
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more than $10,000.
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So in the future, you're going
to give me back my money.
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So it'll be $10,000 plus
something-- and that's
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something is essentially
interest, right?
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So I'll get my money back
and then I'll give
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you back the watch.
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So if you think about it, this
is completely identical
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economically to what we
did up here, right?
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I gave you $10,000.
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You gave me the watch
as collateral.
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When you pay back the $10,000
plus interest, I give you back
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the watch, right?
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But at no time did I really
have real, legitimate
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ownership of that watch.
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Well, in this situation,
the same thing happens.
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You come to me.
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I give you money.
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You give me the watch, but I
bought it from you so I have a
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receipt too.
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I am the official owner of the
watch while you have my money,
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but we have an agreement that at
some future date, you will
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repurchase the watch from me.
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for $10,000 plus some amount,
which is essentially the
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interest. So this was a loan
collateralized by a watch, but
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the only difference here is that
instead of it just being
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collateral, you actually sold
it to me and then we had a
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repurchase agreement-- and it
took me six minutes to say
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that, but I think it was worth
it-- where you agree to
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repurchase the watch
at some point.
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It's actually I'm the holder of
the repurchase agreement.
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So the money lender-- so
I get the watch and
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a repurchase agreement.
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We'll call that a repo.
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So these are two assets that I
now have-- the watch plus the
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repurchase agreement.
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You get the money.
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And it's actually called
a reverse repo, from
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your point of view.
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But the whole idea here is this
agreement forces you to
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buy the watch back at the
original amount that you
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essentially borrowed from me
plus some interest. And this
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essentially forces me
to sell it to you.
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So we have a-- it's
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essentially a forward contract.
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A forward contract is just an
agreement to transact in the
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future at some given price.
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And the whole reason why I did
this is because this is how
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the Fed transacts.
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This is how the Fed lends,
especially with
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the discount window.
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Sometimes it's called a
repo transaction or
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a repurchase agreement.
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And so what the Fed does when
someone comes to it at the
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discount window-- let me
actually draw proper balance
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sheets now.
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Let's say that this over
here is a bank in need.
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I won't worry about the
right-hand side of the balance
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sheet too much.
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It has some liabilities,
some equities.
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Let's say it has a
ton of assets.
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Let's say that these right
here are treasuries.
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But it's all out
of cash, right?
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This is the bank.
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It's all out of cash and on the
other hand, we have the
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Federal reserve.
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Let me see if I can draw their
balance sheet properly.
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And the Federal reserve-- well,
for the most part, these
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are going to be treasuries
right now.
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It has some liabilities.
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I won't go into that just yet.
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It has some equity.
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And let's say you're one
of these pariah banks.
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No-one's willing
to lend to you.
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Your depositors are taking
out their money.
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So you need to convert some of
these treasuries into cash.
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You don't want to just dump
them on the market.
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Maybe there are other assets
that are less liquid and if
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you just dump them, you won't
get the value you want.
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So essentially you enter into
a repurchase agreement with
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the Federal reserve.
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So this is the Fed reserve.
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You go to the Federal reserve
discount window.
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The discount rate might be-- I
don't know-- 5% on an annual
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basis, but we won't get into
the technicalities of that.
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You say, hey, Fed, lend
me some money.
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And the Fed says, OK, let me
print some money for you.
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So these are the liabilities
notes outstanding and then he
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prints some Federal reserve
notes, but instead of just
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lending the money to you and
then keeping these treasuries
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as collateral, the Federal
reserve will actually buy
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these-- it'll enter into a
repurchase agreement with you.
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So the mechanics of that is that
the Federal reserve will
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buy these treasuries from you.
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So now all of a sudden, the
treasuries-- the Federal
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reserve notes will go from from
the Federal reserve to
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you and then your cash will go
to-- then your treasury notes
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will go to the Federal
reserve, right?
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This is cash-- Federal reserve
printed cash, gave it to you,
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and then essentially bought
treasury notes from you.
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So now these are
treasury notes.
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These are the treasury notes
that were here before.
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But it has a repurchase
agreement where you agree at
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some future date to unwind this
transaction, where you're
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going to buy back your
treasuries and you're going to
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pay the amount that the treasury
paid you initially
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plus some interest, right?
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So the basic way to view it
is, this was just a loan.
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You just borrowed this much
from the Federal reserve.
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The Federal reserve kept your
treasuries as collateral, but
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it actually had formal
ownership over it.
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And that's what differentiates
a repo agreement from just a
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traditional collateralized loan,
but in the future you're
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going to buy back those
treasuries for the amount the
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Federal reserve had originally
bought them from you for plus
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a little bit of interest. You're
going to pay a little
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interest and that interest is
going to be dictated by the
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discount rate.
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Anyway, all out of time.
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In the next video, we'll
actually look at the Federal
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reserve's balance sheet.
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