This post will summarize a unique historical situation when an interest rate on an asset became negative.
The repo market is a market for short term, low rate, collateralized loans, often done between between large entities. The collateral on these loans are government securities, such as treasury notes, so someone will loan someone money, and in return, they will receive a t-note as collateral until the loan is repaid. Here is a quick visual representation of how the repo market works.
To get to the story, in the summer of 2003, there was a rising interest rate on intermediate t-notes leading investors to take a short position on these government securities. By investors selling short on their t-notes, the market was coming up short on the necessary securities to complete the repo agreements.
With all of the short sales of t-notes, people were so desperate to get their hands on collateral that they owed people through a repo agreement, that they were willing to make a loan for lower and lower rates, just so they were able to receive collateral in return. The repo market is essentially just a bunch of people receiving loans, then writing IOU’s for collateral that they don’t currently have in their hands. That means that they have to scramble to come up with this collateral when it is due. The people who owed collateral in 2003 were so desperate to come up with collateral, that they were willing to loan money for free in order to receive a piece of collateral in return as part of that deal.
I know that may not make much sense, but all you need to understand is that collateral exchanges hands frequently, and when there isn’t enough of it, it causes issues in the repo market due to the fact that it depends on people being able to return collateral on time when a loan is repaid.
So moving on, in 2003, certain interest rates in the repo market ended up at 0% because of the need to return collateral owed through repo deals. This rare 0% interest rate led to a situation where those holding onto collateral had no incentive to return it as it would not cost them anything extra in terms of interest. These were called strategic fails, and were a systematic issue during the summer of 2003.
With the high amount of fails on collateral return, it created difficulties for dealers in this market because of the extra cost of attempting to track down missing collateral. They were forced to allocate extra resources and spend more money dealing with the fails in the market. Finally, dealers realized that they would be cheaper to receive a negative interest rate on their loans, in order to receive the collateral that they desperately needed. In other words, they were paying people to take a loan, just so they were able to receive a security that they were owed.
This situation was more complicated than I made it seem (hopefully) but here is an article that gives a much more in-depth explanation of this situation.
Complicated subject, congrats for tackling. This all became more fun going forward from 2003 when financial institutions bundled and sold mortgage backed securities and commercial backed securities that had insufficient or no collateral, with property that was over valued and based on borrowers who were not qualified for the loans. This of course led to the most recent crash in the financial markets in 2008 and the failure of a number of large financial institutions. I’m wondering what you think about Congress’s recent attempts to regulated these complicated markets and instruments to prevent these situations. Will it work?