Repo Rate vs Repo Margin (Haircut)

CFA Level I Fixed Income
#1

Hi everyone,

I am having some difficulties with the factors that affect the repo rate and the repo margin.

Why is the credit quality of the counterparty only considered for the haircut/repo-margin and not for the repo rate. If I borrow money from a bank to buy a house, the interest rate that I end up paying, will depend on my credit rating after all? Why is it different here. This would imply that if two banks want to borrow money from the central bank and provide the same collateral (say a government bond of high quality), and one of them has a higher creditworthiness, both will still pay the same repo rate. The only difference will be, that the one with the lower credit quality gets a smaller loan (or bigger haircut). Can anyone provide an intuition for this?

#2

Let me explain to you with an example.

Consider there is an ABC Bank Which issue loan to client Z Inc.( A Non Banking financial company) of amount $ 90,000 for collateral of $100,000**( Which is also a Financial asset)** , Giving a haircut of 10,000

Situation 1 ( You wronghly estimate the credit worthiness of Z Inc.)

Suddenly the market crashes and the collateral value is down to 85,000 . Now at the time of repayement If the company Z is not strong in credit It will tends to default and you will sell the asset but end up with 5000 loss. IF you would know in starting that Z will default as it is also a financial company and in financial crisis both its assets/collateral and credit worthiness will go down , you would have given a loan of 70,000 for the collateral of 100,000

Situation 2 ( You Correctly estimate the credit worthiness of Z Inc.)

In this case even if the markets are poor the Z Inc would have paid you full 100,000

This recently happened in India where Kingfisher airlines Became a Wilfull Defaulter as the loan issued to him was 7500 Cores Rupees and the physical collateral was only 155 Cores rupees , See the difference in the (7500 - 155 ) . To avoid such situation we consider very high creditworthiness

#3

Thank you for the example. However, I was actually asking about the repo-rate, not about the haircut. I do understand why for the haircut the creditworthiness of the borrower AND the quality of the collateral plays a role. BUT for the repo-rate we completely ignore the creditworthiness and just look into the quality of the collateral.

To use my example from above, imagine we have two companies, A and B. A has a high credit rating and B has a low credit rating. Both receive a loan for from a bank and use the same security as collateral (AAA government bond with value $100,000):

Now A will have a small haircut, because its credit rating is high and the collateraly provided is of high quality.

B will have a large haircut, because its credit rating is terrible, in spite of the collateral being of high quality.

So far this akes sense to me. BUT now we have to determine the repo rate, and for this, both get the same repo rate because we ignore the credit wothiness of the borrower and only consider the quality of the collateral. That is, both pay, say 5% repo margin. Why is that? Shouldn’t we charge company B a higher repo rate, due to their lower creditwothiness?

#4

The truth is we will be charging the different rates from the above persons .

There is a difference between Repo rates and repo margins look to the trade below

Diagram 1 - start

Trade details:

Principal: $10,000,000 Bond price: 100% Repo principal: $10,000,000 Repo rate: 5.00% Actual/360 Term: 7 days Borrower Lender

Diagram to show repo startDiagram 2 - maturity

Trade details:

Principal: $10,000,000 Bond price: 100% Repo principal: $10,000,000 Repo rate: 5.00% Actual/360 Repo interest: $9,722.22

Diagram to show repo maturity

As you have noted the repo rate is same at 5% without any credit risk , as the collateral is exchanged at par value and there is a interest of 9,722.22 for 7days

Now Repo margin

Sincerely , the lender of the money does not care if the bond price is falling IF he is damm! sure that he will receive his $10 million with interest amount , Because he has to just return the collateral to the borrower and receive the payement.

The question arises that What IF the borrower defaulted and by the time we went to the market to sell the security the market value of the collateral security has drop , so the risk starts from the risk of borrower’s default.

According to Wikipedia

While classic repos are generally credit-risk mitigated instruments , there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold, at the maturity date. In other words, the repo seller defaults on their obligation. Consequently, the buyer may keep the security, and liquidate the security to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this risk, repos often are over-collateralized as well as being subject to daily mark-to-market margining (i.e., if the collateral falls in value, a margin call can be triggered asking the borrower to post extra securities ).

Either you can go for a margin call in the middle of life of the repo aggrement or you can go for an Haircut in the starting of the Aggrement itself based on the probability of defualt and chances of security to go down in the value.

Now the answer to your question:-

Client A: - He will get the repo rate of 5% on 10 Million

Client B:- He will get the repo rate of 5% on 9 Million ( After haircut because of counterparty credit risk) but has to pay the same 10,009,722.22 at the end . Thereore the effective rate of borrowiing of B is 11.219% (cosidered for whole 1 Year than 7 days for easy calculation) will be higher that A.

Hope This help!

Still any doubt please feel free to ask

#5

Thank you for your elaborate response.

I think I might have a wrong understanding of the haircut or repo margin. I thought that this affected the difference between what I hand over as collateral and how much they offer me as a loan. But the actual interest payment is sill based on my actual amount that I received.

Say I borrow money from a bank and leave as a collateral a goverment bond that has a markte price of $100,000. Now let’s say the bank applies a 10% haircut, thus they don’t lend me $100,000 but only give me $90,000. But it was my understanding that I only owe them $90,000 (1+repo_rate) at the end and not $100,000(1+repo_rate) . After all they only borrowed me that amount and not $100,000.

#6

Your welcome!

#7

Ok sorry to bring this up again, but I really don’t see why the borrower has to pay the value of the collateral. In the curriculum it says: (Reading 53, p.386):

Although both parties to a repurchase agreement are subject to credit risk, the agreement is structured as if the lender of funds is the most vulnerable party. Specifically, the amount lent is lower than the collateral’s market value. The difference between the market value of the security used as collateral and the value of the loan is known as the repo margin, although the term haircut is more commonly used, particularly in the United States. The repo margin allows for some worsening in market value, and thus provides the cash lender a margin of safety if the collateral’s market value declines. Repo margins vary by transaction and are negotiated bilaterally between the counterparties.

It does not say, that the borrowers actually owes the amount of the collateral. The haircut is just a protection against a decline in market value of the collateral but the borrower still seems to owe the amount agreed upon, which does not appear to have anything to do with the value of the collateral.

So to use my example again, I borrow $90,000 from the bank and give them my security with a current market value of $100,000 as collateral which they deem to be worth $90,000 because it is so volatile. At the end of the loan I pay them back (1+repo_rate)*90,000, right?

#8

yes you are correct! While taking the money you are submitting the collateral worth of 100,000 and taking loan of 90,000. At the time of payback he will pay (1+repo_rate)*90,000

I also found out the same that the collateral is just for security purpose , It is just used for safety purpose and that why it is overcollaterlization.

Thanks for correcting me!

#9

Ah ok, I am glad we figured it out. That brings me back to my original question then:

If two companies, A and B , apply for a loan, and A has high credit quality , B has low credit quality , and both use the same security as collateral, then both will end up with the same repo-rate, because the r epo rate does NOT take the credit quality of the borrower into account (according the curriculum, see citation in the first post). To summarize:

A walks into a Bank, provides a AAA-government bond of $100,000 as collateral and because A has such high credit quality, the haircut is pretty small. A gets, say $99,000 at a repo rate of say 5%.

B walks into a Bank, provides a AAA-government bond of $100,000 as collateral and because B has such low credit quality, the haircut is pretty large. B gets, say only $80,000 at a repo rate of say 5%.

But both companies end up with the same repo rate. Shouldn’t the repo rate be higher for a company with low credit quality? When you get a loan to buy a house, the bank typically also checks your credit score and the interest rate you end up paying is higher is your credit score is bad. Why is it different here?

#10

@Tartaglia - You are answering your own question.

Repo rates are rates in the market and priced off General Collateral. The market can’t have a higher repo rate just because your borrower has high credit risk. If the market itself is in a credit situation then repo rates go higher. Since credit events generally pertain to the respective counterparty (borrower), a haircut comes into picture which incorporates the buyer’s credit risk also apart from the quality of collateral.

If what you are saying has to happen, then the haircut also should be the same across all repo transactions in the market for that respective collateral and that’s not possible.

#11

I see, thank you for clarifying that.

So if I understand you correctly:

For each security that is accepted as collateral, there is a market wide repo rate that applies to everyone who provides that security as collateral (it doesn’t matter who it is, they all get the same repo rate). Say for a AAA government bond, everyone pays a repo rate of 1%. For a B government bond everyone pays 5%.

Now the amount that is actually lent to that spefific person or company depends on their credit quality. So for the the same AAA government bond, a person with high credit quality can borrow more compared to a person with less credit quality.

So in the housing market a bank would lend person A (high credit quality) and person B (low credit quality) the same amount if they offer the same collateral (a similar high quality house in a nice neighborhood) and charge person B a higher discount rate (because of their lower credit quality). The bank cannot use a haircut here, because the borrower needs the entire amount of the collateral (the house) as a loan to pay for the house.

In the repo market the situation is reversed. The repo rate cannot be adjusted because it is set for the entire market. Thus, the only thing that can be adjusted on an individual borrower basis is the haircut, and that is what we do here. For borrowers with low credit quality we simply lend them less money for the same collateral but charge the same repo rate.

Is this correct?

#12

yes

#13

Alright, got it. Thank you.