Big investors, including hedge funds, mutual funds and real estate trusts, are replacing banks as the biggest users of the overnight funding market that played a key role in the financial crisis.
The repo market, in which borrowers pledge securities as collateral against very short-term loans, was once a popular method for banks to source cheap financing. But the strategy proved destabilising in 2008, when lenders in the repo market lost confidence in mortgage-backed collateral and pulled back on funding.
Since 2008, the repo market has been shrinking as banks have shifted to longer-term financing in response to new regulatory capital rules and other post-crisis pressures. What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds.
These investors are turning to repo to boost returns during an era of low rates. By using more borrowed money, or leverage, they can take larger positions, but they are also taking a bet that markets will remain stable.
Janet Yellen, Federal Reserve chairman, has stressed that rates in the US could stay low even if unemployment and inflation return to more normal levels.
The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009.
Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.
Industry participants say there is ample anecdotal evidence that other types of big investors are lending out more of their assets to generate greater returns.
“It’s becoming more of a popular strategy,” said one repo specialist at a large bank. “It’s an opportunity to enhance yield and hit the return hurdles that investors are looking for.”