Markets were rattled last week after the Federal Reserve said it conducted an open market operation to inject liquidity into the overnight repo market.
New York Fed President John Williams said Monday that the Fed acted quickly and the problems are resolved for now, but investors are understandably concerned following news the Fed injected another $105 billion on Tuesday.
Nate Tobik, investor and founder of CompleteBankData.com and author of “The Bank Investor’s Handbook,” joined Benzinga's PreMarket Prep show Tuesday and explained the repo market and what went wrong last week.
Tobik said the need for an overnight repo market starts with trade imbalances at brokerages at the end of each trading day. Financial institutions need funding to balance out these temporary imbalances.
“You get an overnight loan, then your clients go on trading the next day,” Tobik said.
Nursing The Market
During the financial crisis of 2008, the overnight lending market froze up completely, and the Federal Reserve was forced to step in and “nurse it along” for roughly a decade, Tobik said.
Since the crisis, banks have been forced to keep large amounts of excess capital reserves on their balance sheets.
These banks can make a little bit of extra cash on these reserves by lending them out overnight at a rate around 2%.
The borrowers must post some form of collateral for those loans.
Last week, the median rate on those overnight loans jumped to 5% — and Tobik isn’t buying the Fed’s explanation.
“The narrative we hear was it was just an imbalance thing due to taxes. It was a one-time thing,” Tobik said.
Collateral In Question
Instead, given the ongoing operations by the Fed, Tobik said the issue is likely with what’s being posted as collateral.
“That tax imbalance thing, seeing as how the Fed has stepped in and said we’re going to keep doing this for the next month, that’s definitely not true,” he said.
The fact that the Fed is now selling 14-day repos is a red flag.
“Instead of just an overnight where we’re posting collateral for just one night on something, there’s apparently assets out there that no one wants to lend on for 14 days … I don’t know what’s being posted, but there are banks looking at this stuff and saying, I’m not sure if I’m going to get my money back in two weeks. It’s a cause for concern,” Tobik said.
IPOs To Blame?
Unfortunately, Tobik said the average retail investor doesn’t have the visibility to see exactly what’s going on with these overnight positions and whether they pose a threat to the entire market.
“It’s not the subprime mortgages, but there’s something equally as toxic that no one wants to put a finger on,” he said.
Tobik said one possible contributor is extremely volatile and unpredictable recent IPOs, such as Beyond Meat Inc BYND, Chewy Inc CHWY and Roku Inc ROKU.
“There is a lot of junk being pushed into the market, and the brokers backing these things don’t seem to have a ton of confidence,” Tobik said.
“They’re pushing leaky boats into the ocean and hoping it floats far enough away that nobody sees who pushed it in.”
In addition, Tobik said earnings expectations are so high today that even small EPS and guidance misses can trigger huge overnight swings in share price.
“If you’re doing this repo trade, I don’t know if I want to be holding this thing through earnings, because what if they miss by a couple of cents? That collateral is now worth a lot less, and it all trickles through,” he said.
Tobik isn’t the only skeptic of the tidal wave of recent IPOs. Buying shares of the newest stock to hit the market can be exciting, but large tech IPOs traditionally have poor returns in their first year of trading.
But even investors that are not buying IPOs should keep an eye on the overnight lending market until more is known about what is causing these liquidity issues.
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