Repurchase agreements: a refresher course.

• Author: McArthur, Steven
• Position: Reprint

Repurchase agreements have long been a safe way to invest short-term or overnight cash. But given the precarious condition of a number of banks and the nervous attitude of many finance officers, now is an opportune time to review the basics as well as recent rulings.

Repurchase agreements, or repos, are financial instruments in which an investor purchases securities from a bank or dealer and, at the same time, the selling bank or dealer contractually agrees to repurchase the securities at the same price (plus interest) at some mutually agreed-upon future date. The parties to the agreement--the governmental entity and the bank or dealer--are called counterparties. Historically, repos have been used as a way of earning incremental investment income.

A SIMPLE OVERNIGHT REPURCHASE TRANSACTION

The following is a typical scenario. A governmental entity determines the amount of excess liquidity it has on an overnight basis. The government then enters into a repurchase agreement with its bank for that amount, with the goal of earning incremental interest. It invests $1 million.

The bank identifies a security in its portfolio, free and clear of any encumbrances, and agrees to sell that security to the government with a written agreement to buy it back the following morning at a higher price. In this example, the bank sells the government a U.S. Treasury Bond with a $1.02 million face value, or par. The market price is par value, or 100 percent, and the agreed-upon margin is 102 percent. The agreed-upon repurchase price the next day is $1 million plus $27,000, a 1 percent annual rate.

The bank notifies its safekeeping agent, a non-related third party, to transfer ownership of the security to the governmental entity, and the bank also instructs the agent to transfer the security back the following morning in a way that ensures the governmental entity has ownership and receives its cash back. The bank sends a written confirmation on a daily basis to the government, clearly listing and verifying the issuer, the face value, coupon (the coupon rate of a bond is the amount of interest paid per year, expressed as a percentage of the face value), CUSIP (the identification number the Committee on Uniform Security Information Procedures assigns the security), market value, and amount invested. This information is used by the government entity to update its accounting records.

In reality, this process is almost totally automated. Only rarely would a human...