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ill)@\fill1 CQJ k IT 1m11 © J'(\\ rC'!C§" 5\ 'l'fJ LJ, . 11)) November 1 2,1 982 Retail RPs Retail repurchase agreement (retail RP) is hardly a household term. Yet, in the last eighteen months it has emerged as an important financial instrument, rivaling in popularity the more familiar deposit instruments offered by banks and savings and loan associations. Lacking the authority to offer a consumer deposit instrument competitive with money market mutual funds, these depository institutions have turned to retail RPs as a means of retaining household funds. Retail repurchase agreements combine the advantages of a market rate of return and short maturity in an instrumentthat could be viewed as a collateralized loan to the issuing financial institution. They are available to consumers in minimum denominations of $1,000 or even lower. The high yields, Iiqu idity and low minimum investment requirements of retail R Ps-a combination of features that are only now appearing in consumer deposit instruments-have made this instrument extremely popular. As of August 1982, the outstanding amount of retail RPs had grown to an estimated $21.0 billion nationally. Despite the attractiveness of retail RPs,this type of uninsured non-deposit instrument may entail risks not associated with federally insured deposits. Therefore, an investor must evaluate the risk/return tradeoff before purchasing them. Rising popularity All repurchase agreements -whether wholesale, which normally trade in minimum denominations of $1 million, or retailinvolve two transactions: the sale of a finc;lncial asset (usually U.S. Treasury or Federal agency securities) and the repurchase of that asset by the original seller. The terms of both transactions are agreed upon in advance, with the original seller agreeing to repurchase the securities for a higher price than the original sales price. While this two-part transaction seems unusualty complex, in practice, repurchase agreements have become a relatively convenient way for borrowers (most notably, securities brokers/dealers and depository institutions) to obtain short-term funds. In effect, the securities sold to the investor in the initial transaction are collateral for the loan that the investor is making to the seller. Likewise, the higher price the seller pays to repurchase the securities at a later date represents the repayment of the principal and interest on the loan. The dramatic upward trend in market interest rates over the last decade, combi ned with interest rate and maturity restrictions, fostered more extensive use of retail RPs. Securities brokers and dealers traditionally have relied on the RP vehicle to finance their holdings of securities. Depository institutions also came to rely on wholesale RPsto hold onto liquid balances of corporations and state and local governments. During the 1970s, wholesale RPsbecame an important source of shortterm funds for banks, supplementing Fed funds, large denomination time deposits (CDs), Eurodollar borrowings 'and other managed liabilities. In the 1980s, the persistently high level of market interest rates spurred an even broader application of the RP instrument, namely, its use in transactions between a depository institution and its retail customers. By setting aside a pool of government and/or Federal agency securities as backing for its retail RPs,a depository institution could sell shares in that pool in denominations less than $100,000 and agree to repurchase them at a later date. As of recently this type of instrument, which is not a deposit and is not subject to reserve requirements or deposit-rate ceilings, has also been authorized with an automatic renewal feature and without maturity restrictions. u.s. ffi)cB.\Jffi (G)11 Jk Opinions expressed in this newsletter do not necessarilv reflect the vievvs ot the rnanagement of the Federal Reserve Bank of San Francisco, or of the Board of Covernors of the Federal Reserve System. by the issuing institution is of paramount importance. Depository institutions have had the authori ty to offer reta i I repu rchase agreements as an instrument to compete with money market funds since August 1 979, when the banking regulators exempted short-term, smalldenomination RPs from deposit-rate ceilings. But neither banks nor thrifts took advantage of the opportunity to any significant extent until summer 1981, when they began offering retail RPsat premium rates to attract AIISavers deposits and to cut the outflow of balances to money market funds. In legal parlance, investors in retail RPsmust have a perfected security interest in the underlying pool of securities for their investment to be protected against the issuing institution's default. Otherwise, the retail RP investors would be treated as general (unsecured) creditors of the failed institution and would only receive their proportionate share of the proceeds of the institution's total liquidated assetsafter the depositors and others with senior claims on the institution's assetshad been satisfied. Without a perfected security interest, then, retail RP investors run the risk of losing some or all of their investment. The response was overwhelming. By September 1981, retail RPsoutstanding had grown to $13.3 billion. While a substantial portion of these funds was subsequently transferred to All-Savers certificates, many investors preferred the liquidity retail RPsoffered. More recently, retail RPshave also become popular as the market-return instrument used to invest lIexcess" checking balances arising from deposit IIsweeping" arrangements. Unfortunately, the existence of a perfected security interest in the underlying pool of securities is frequently difficult to ascertain. It is possible that a court might decide that the retail RP investors did not have a perfected security interest under relevant state law despite good faith reports on the part of the failed institution to establish one. Generally, "perfection" requires transfer of the underlying securities to the custody of a third party (such as a bank), which would hold the securities for the account of the customer, not the issuing institution. Risk While retail- RPsare in some respects more attractive than presently available deposit instruments, they are by no means a perfect substitute for them. Indeed, since retail RPs are not deposits, investors' funds are not insured by either the Federal Deposit Insurance Corporation or the Federal Savings and Loan Corporation. The investors in the retail RP program set up by the failed Mouht Pleasant Bank and Trust Company in Iowa, for example, found to their dismay that they may not have had a perfected interest in the securities underlying their RPs.The FDIC recently ruled in this particular case that it will not regard the RP holders' claims on any of the bank's assets as having precedence over claims of depositors and other general creditors of the bank. As a result, these investors may stand to lose some or all ofthe $350,000 or more they had invested. Of course, retail RPs are backed by a pool of U.S. government and/or Federal agency securities. And to protect the investor, regulatory authorities require. that the market value of that pool be at least equal to the principal of the issuing institution's obligation as of the date of the issuance of the RPs.This requirement, however, does not eliminate all risks associated with retail RPs.Two risk factors, in particular, are discussed here. Perfected security interest First, because the safety of a retail-RP holder's investment depends on the pool of securities that is offered as security, investors' ability to dispose of that pool in the event of default In the final analysis, since the existence of a perfected security interest is frequently ambiguous, an investor seeking to minimize the risk of loss from the absence of a perfected 2 security interest must evaluate the financial soundness of the issuing institution. Next, the investor must decide whether the risk of an adverse ruling regarding the existence of a perfected security interest (should the institution fai I) is outweighed by the yield. interest rates, even if the issuing institution were to fail. On the other hand, the larger the "cushion" provided by the issuing institution, the lower will be the yield offered by that institution since such interest rate protection is costly to provide. Valueof collateral And again, such protection is not the equivalent of deposit insurance; there is likely to remain some risk of loss from particularly large upward swings in interest rates. The investor must decide whether the yield being offered is adequate compensation for that risk. The second risk factor associated with retail repurchase agreements is related to the changing market value of the pool of securities backing the retail RP program. If market interest rates were to rise substantially, it is possible that the market value of the securities that are backing the retail RPscould fall sufficiently to reduce the value of the individual investor's share in that pool of securities. As long as the issuing institution is able to meet its obligation to repurchase RP investors' shares at the specified price (yield), the risk of adverse movements in interest rates will be borne by the institution. However, if the institution fails, and the market value of the securities has fallen, the investor in retail RPscould find that the collateral backing her investment was insufficient to protect the whole of her principal and interest. Institutional backing In sum, retail repurchase agreements, whether offered by banks or savi ngs and loan associations, involve some risk of loss. The existence of risk does not necessariIy make them an unwise investment, of course. However, the potential investor should examine carefully the elements of the individual programs offered as well as the overall soundnessof the issuing institutions before deciding whether the compensation offered is adequate for the risks he or she is assuming. A financially sound institution generally attempts to minimizethis risk by issuing a lower aggregate amount of retail RPsthan the total market value of the pool of securities that is backing them. In this way, the issuing institution provides a cushion that helpsto preserve the investors' share value against unforeseeable interest rate movements. Like any other investment vehicle, the safety of retail RPsdepends ultimately on the issuing institution's ability to meet its obligations. An institution that investors regard as financially sound will be able to offer a lower yield on its obligations, including retail RPs, than would be the case for an institution for which investors feel the likelihood of failure is consequential. Retail RP investments, then, need to be evaluated in light ofthis risk/return tradeoff. Obviously, the larger is the pool of underlying securities relative to the total amount of retail RPsissued, the greater is the investor's protection against adverse movements in market BarbaraBennettand Gary C. Zimmerman 3 U01 SU!4SP • 4Pln • uoSaJO • PPP M AaN • o4 PPI !!PMPH • P!UJoJHP:) • puozPV • P>jsPIV (G) :u. BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollaramounts.in millions) Selected Assets Liabilities and large Commercial Banks Loans (gross, adjusted) investments* and Loans (gross, adjusted) total# Commercial industrial and Real estate Loans individuals to Securities loans U.s.Treasury securities* Othersecurities* Demand deposits total # Demand deposits adjusted Savings deposits total Timedeposits total # Individuals, & corp. part. (Large negotiable CD's) Weekly Averages of Daily Figures MemberBankReserve Position Excess Reserves )/Deficiency ) (+ (Borrowings Net freereserves )/Netborrowed( ) (+ - Amount Outstanding 10/27/82 162,063 142,401 45,617 57,550 23,393 2,308 6,618 13,044 38,732 28,004 31,721 100,090 89,878 37,475 Change from Change from yearago Dollar Percent 10/20/82 656 607 - 338 24 10 - 259 30 79 872 146 167 - 778 807 - 831 - - Weekended Weekended 10/27/82 10/20/82 123 3 120 89 1 88 8,942 10,170 5,947 2,488 126 888 1,000 2,228 170 17 2,444 14,379 12,137 4,367 5.8 7.7 15.0 4.5 .5 63.0 17.8 - 14.6 0.4 0.0 8.3 16.8 15.6 13.2 Comparable year period -ago 72 13 59 * Excludes trading account securities. # Includes items shownseparately. not Editorial comments beaddressed theeditoror to theauthor.... Free may to copies thisandotherFederal of Reserve publications beobtained calling writingthe PublicInformation can by or Section, Federal Reserve Bank of SanFrancisco, P.O.Box7702,San Francisco 94120. Phone (415)544-2184.
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