Let’s say that you’re in
desperate need of money and I have money to lend
to other people. So this is me and this
is my gold chain. So you come to me and say,
Sal, I need $10,000 for a kidney transplant. Can you lend me the money? I’m in desperate need. And I have $10,000. Sure, I’m willing to lend it
to you, but it’s a tough economy and you never know where
that money’s going to go and I don’t know if you’re going
to be able to keep your job after going through this
kidney surgery and all that. So I’m very careful with my
money so I want to make sure that you’re good for it. So we think about it a little
bit and I say, hey, that watch you have on your wrist, that
looks pretty nice. You say, this watch? Let me draw the watch. And I say, yeah, that watch. You’re like, this watch
I got from my great-great-grandfather and it’s
actually worth– I don’t know– maybe it’s a diamond
studded Rolex of some sort and it’s actually worth
$30,000, right? And I know that, clearly because
I’ve already become well acquainted with gold and
diamonds and things like that. So I say, I trust you and
you trust yourself. I’ll lend you the $10,000, but
just so that we all know that everything’s going to be fine,
why don’t you just leave your great-grandfather’s
watch with me? And when you pay back the
$10,000 with a low interest– let’s say it’s 10% a week– when
you pay back the money, the principal, with the
interest, however long you borrow it, I’ll give you
back your watch. You’re like, I don’t
know about that. First of all, 10% a week
sounds like a lot. I was like, well, don’t you just
need it for the kidney transplant tomorrow and then you
can work a couple of weeks and then pay it back. 10% a week’s not bad– and we
all know that that is because you compound that over the year
and it becomes some type of horrendous interest rate. But you’re desperate. You need your kidney and I’m
like, look, you plan on paying me back, right? So you’re going to get your
$30,000 watch back, so what’s there to worry, right? So why don’t you just leave this
with me as collateral? And you say, fine and you leave
your watch and you get your kidney transplant and then
you try to work really hard to pay it back,
but you never can and I keep your watch. And this is how the pawn process
essentially works. You’ve pawned your watch off to
me, but in a less kind of derisive way of talking about
it, you’ve given it as collateral for a loan. And I was willing to give you
the loan because I knew that if you couldn’t pay it back, I
could keep this nice asset. And this happens all the
time in less shady parts of our economy. A bank will give you a loan and
they’ll collateralize it by the house. If you can’t pay the loan,
they keep the house. They want you to put a down
payment on the house so that even if the house devalues, they
still capture back most of their money. And so this is a pretty
straightforward collateralized loan. This is the collateral
you give me. I give you the loan. You pay it back. I give you back the
collateral. Now what if there was a reality
where I don’t– me as the lender, I don’t even like
this notion of collateral and all of that. I actually want to make it
very clear that I have ownership of the collateral
when it happens, right? I don’t want some Feds coming
in and saying, wow, whose watch is this that
you’re holding? Where’s the receipt for this? Where did you get it? Was it stolen from somebody? And it looks all shady and I
probably do have some side shady operations anyway so I
want to know that I own this watch in the event that
you don’t come back to pay the loan. So instead, we could have done
this exact same transaction– so this is you again. This is me again. I’ll draw that top hat
and the moustache. Those are my differentiating
characteristics, maybe the gold chain. And now what I can do is–
because I want ownership of that watch, what I’ll do is I
will buy that watch from you. So you’ll give the watch– so
the watch will literally change hands. So I will buy the watch
from you for $10,000. But we’ll also have
a side agreement. So far it’s almost
identical, right? The only difference between this
and what we did before is, I’m actually selling
the money. I’m actually buying the
watch from you. This is a cash transaction. This wasn’t a loan, strictly
speaking, but the same thing is happening, right? Up here you handed
me the watch and I handed you $10,000. Here, you handed me the watch
and I handed you $10,000. But what we’ll add on to this
is an agreement that at some future date– so this is now. We also going to have an
agreement– and both of us are parties to this– that in the
future, I will agree to sell and you will agree to buy this
watch for me for something more than $10,000. So in the future, you’re going
to give me back my money. So it’ll be $10,000 plus
something– and that’s something is essentially
interest, right? So I’ll get my money back
and then I’ll give you back the watch. So if you think about it, this
is completely identical economically to what we
did up here, right? I gave you $10,000. You gave me the watch
as collateral. When you pay back the $10,000
plus interest, I give you back the watch, right? But at no time did I really
have real, legitimate ownership of that watch. Well, in this situation,
the same thing happens. You come to me. I give you money. You give me the watch, but I
bought it from you so I have a receipt too. I am the official owner of the
watch while you have my money, but we have an agreement that at
some future date, you will repurchase the watch from me. for $10,000 plus some amount,
which is essentially the interest. So this was a loan
collateralized by a watch, but the only difference here is that
instead of it just being collateral, you actually sold
it to me and then we had a repurchase agreement– and it
took me six minutes to say that, but I think it was worth
it– where you agree to repurchase the watch
at some point. It’s actually I’m the holder of
the repurchase agreement. So the money lender– so
I get the watch and a repurchase agreement. We’ll call that a repo. So these are two assets that I
now have– the watch plus the repurchase agreement. You get the money. And it’s actually called
a reverse repo, from your point of view. But the whole idea here is this
agreement forces you to buy the watch back at the
original amount that you essentially borrowed from me
plus some interest. And this essentially forces me
to sell it to you. So we have a– it’s essentially a forward contract. A forward contract is just an
agreement to transact in the future at some given price. And the whole reason why I did
this is because this is how the Fed transacts. This is how the Fed lends,
especially with the discount window. Sometimes it’s called a
repo transaction or a repurchase agreement. And so what the Fed does when
someone comes to it at the discount window– let me
actually draw proper balance sheets now. Let’s say that this over
here is a bank in need. I won’t worry about the
right-hand side of the balance sheet too much. It has some liabilities,
some equities. Let’s say it has a
ton of assets. Let’s say that these right
here are treasuries. But it’s all out
of cash, right? This is the bank. It’s all out of cash and on the
other hand, we have the Federal reserve. Let me see if I can draw their
balance sheet properly. And the Federal reserve– well,
for the most part, these are going to be treasuries
right now. It has some liabilities. I won’t go into that just yet. It has some equity. And let’s say you’re one
of these pariah banks. No-one’s willing
to lend to you. Your depositors are taking
out their money. So you need to convert some of
these treasuries into cash. You don’t want to just dump
them on the market. Maybe there are other assets
that are less liquid and if you just dump them, you won’t
get the value you want. So essentially you enter into
a repurchase agreement with the Federal reserve. So this is the Fed reserve. You go to the Federal reserve
discount window. The discount rate might be– I
don’t know– 5% on an annual basis, but we won’t get into
the technicalities of that. You say, hey, Fed, lend
me some money. And the Fed says, OK, let me
print some money for you. So these are the liabilities
notes outstanding and then he prints some Federal reserve
notes, but instead of just lending the money to you and
then keeping these treasuries as collateral, the Federal
reserve will actually buy these– it’ll enter into a
repurchase agreement with you. So the mechanics of that is that
the Federal reserve will buy these treasuries from you. So now all of a sudden, the
treasuries– the Federal reserve notes will go from from
the Federal reserve to you and then your cash will go
to– then your treasury notes will go to the Federal
reserve, right? This is cash– Federal reserve
printed cash, gave it to you, and then essentially bought
treasury notes from you. So now these are
treasury notes. These are the treasury notes
that were here before. But it has a repurchase
agreement where you agree at some future date to unwind this
transaction, where you’re going to buy back your
treasuries and you’re going to pay the amount that the treasury
paid you initially plus some interest, right? So the basic way to view it
is, this was just a loan. You just borrowed this much
from the Federal reserve. The Federal reserve kept your
treasuries as collateral, but it actually had formal
ownership over it. And that’s what differentiates
a repo agreement from just a traditional collateralized loan,
but in the future you’re going to buy back those
treasuries for the amount the Federal reserve had originally
bought them from you for plus a little bit of interest. You’re
going to pay a little interest and that interest is
going to be dictated by the discount rate. Anyway, all out of time. In the next video, we’ll
actually look at the Federal reserve’s balance sheet.