REPURCHASE AGREEMENTS A Refresher Course

1 BY STEVEN MCARTHURREPURCHASE AGREEMENTSA Refresher CourseThis article was reprinted from the October 2009 issue of theGovernment finance Officers association s AGREEMENTS have long been a safe way toinvest short-term or overnight cash. But given the precarious condition of a number of banks and thenervous attitude of many finance officers, now is an oppor-tune time to review the basics as well as recent AGREEMENTS , or repos, are financial instrumentsin which an investor purchases securities from a bank or dealer and, at the same time, the selling bank or dealer con-tractually agrees to REPURCHASE the securities at the sameprice (plus interest)

2 At some mutually agreed-upon parties to the agreement the governmental entityand the bank or dealer are called , repos have been used as a way of earning incre-mental investment SIMPLE OVERNIGHT REPURCHASE TRANSACTION The following is a typical scenario. Agovernmental entity determines theamount of excess liquidity it has on anovernight basis. The government thenenters into a REPURCHASE agreement withits bank for that amount, with the goal of earning incremental interest. It invests $1 bank identifies a security in its portfolio, free and clearof any encumbrances, and agrees to sell that security to thegovernment with a written agreement to buy it back the following morning at a higher price.

3 In this example, the bank sells the government a Treasury Bond with a $ million face value, or par. The market price is par value,or 100 percent, and the agreed-upon margin is 102 agreed-upon REPURCHASE price the next day is $1 millionplus $27,000, a 1 percent annual bank notifies its safekeeping agent, a non-related thirdparty, to transfer ownership of the security to the governmen-tal entity, and the bank also instructs the agent to transfer the security back the following morning in a way that ensuresthe governmental entity has ownership and receives its cash back. The bank sends a written confirmation on a dailybasis to the government ,clearly listing and verifying the issuer,the face value, coupon (the coupon rate of a bond is theamount of interest paid per year, expressed as a percentage ofthe face value), CUSIP (the identification number theCommittee on Uniform Security Information Proceduresassigns the security), market value, and amount invested.

4 Thisinformation is used by the government entity to update itsaccounting reality, this process is almost totally automated. Onlyrarely would a human become involved in an overnightrepurchase agreement . The governmental entity s primarychecking account is typically set up to have a threshold or target balance, and anything left over is swept into a repur-chase bank s computer aggregates all swept balances from allof its customers to find the total amount of securities it needsto sell, then allocates the securities to each customer andinforms the custodian. A daily confirmation is prepared and mailed.

5 A sum total of all daily inter-est paid is shown on the monthly check-ing account statement, and the entitybooks that amount as TO CONSIDERAll investment decisions need to bemade with caution, even regarding trans-actions broadly considered to be lowrisk. Governments that use REPURCHASE AGREEMENTS still needto play it safe. For example, someone needs to open the dailyconfirmations and verify that the information is correct. Fewentities take the time to do so, and many do not even open theenvelope. Similarly, make sure your organization has all thepaperwork necessary for controlling securities. Generally,three conditions need to be met.

6 First, the daily written confirmation should clearly identify the security that is subject to the REPURCHASE agreement . The agreement shouldappoint the bank as the entity s agent in the event of a defaultand provide the entity with the express authority to instruct the agent to sell the securities. Finally, the agree-ment should prohibit the bank from substituting how your bank values securities, and how are several methods used to mark securities to market(rather than valuing it at its cost or its book value), includingmathematical modeling and getting actual market bids, andOctober 2009 | government finance Review41 All investment decisions needto be made with caution, evenregarding transactions broadlyconsidered to be low finance Review| October 2009you should feel comfortable with themethod employed.

7 It is also a good prac-tice to find out how frequently yourcounterparty marks the securities tomarket value. Not all counterpartiesmark to market daily, and some do so only quarterly. Many organizationsrequire a higher margin (the difference between the actualmarket value of the security and the value the lender assignsto the security this is sometimes called the haircut ) forbanks that do not mark to market daily. Generally, haircuts are between 102 percent and 112 percent. Factors to take into account in determining the appropriate amount are the issuer, the coupon rate, the maturity date, and the level of NEW RULESNew Federal Deposit Insurance Corporation (FDIC) rulingshave made taking care of the details more important FDIC has noted a potential problem with the varietyof master REPURCHASE AGREEMENTS that exist, given theincreased number of failed banks during the current ecnom-ic troubles (see Banking Due Diligence in the New FinancialWorld in this issue for more information about failed banks).

8 Master REPURCHASE agreement refers to the blanket agreementthat governs an entity s agreement with its bank or counter-party, and the wording in or structure of some of these agree-ments could cause the agreement to be deemed a loan to thebank rather than a purchase of securities from the bank. If the bank fails, a jurisdiction with this sort of agreement will fall into a creditor status. In some instances, a sweep cus-tomer could find that the amount swept is classified as a bank deposit and subject to FDIC insur-ance limits, currently $250,000. This doesnot take into account the FDIC s tempo-rary Transaction Account GuaranteeProgram, or TAGP, which is currently set to expire at the end of extensionto June 30, 2010, has been proposed,however, which might temporarily enhance FDIC coverage,providing unlimited coverage to transaction accounts andsome negotiable order of withdrawal accounts.

9 However,not all banks elected to participate. It is up to a jurisdiction toconfirm if the program is in effect and that its bank has optedto participate. (See for more information.)As of July 1, 2009, banks were required to review their existing AGREEMENTS and notify all customers how their sweptbalances would be classified if the bank should fail. It should be noted that this notice was required of all banks,regardless of safety or soundness, so it does not indicate that there are any problems with the bank. FDIC Final Rule S (e), officially known as the Final Rule onProcessing of Deposit Accounts in the Event of an InsuredDepository Institution Failure and popularly known as theFailed Bank Rule, sets out the criteria for all sweep accountoptions.

10 The rule does not single out REPURCHASE agreementsfor notification but does include all sweep investmentoptions, including those beyond the scope of this banks took this opportunity to review their masterrepurchase agreement and ensure that the language transferscontrol of sold securities to the buyer. There were some banks that have since modified their AGREEMENTS and subse-quently sent out notices to any clients that were all securities purchasedin light of the jurisdiction sinvestment new regulations provide further protection to bank cus-tomers, so change of terms were often included in IS REQUIRED NOWAs the FDIC found, users of REPURCHASE AGREEMENTS bothcounterparties might have become complacent.