Securities and Exchange Commission v. Miller

Repurchase agreements, also known as repos, were complex transactions that formed an important part of the financial industry. In a typical repo, the counterparties simultaneously entered into two agreements. In the first agreement, one party, the buyer, agreed to buy from the seller certain specified securities at a specified price. In the second agreement, the seller agreed to repurchase the same securities from the buyer at the same price plus a specific amount of interest. In practice, although it was structured as a repurchase, the transaction functioned as a loan. Therefore, each party played two roles. The buyer in the transaction functioned as the lender, and the seller in the transaction functioned as the borrower. Although the repo functioned as a secured loan, the parties often chose to enter into a repo in order to avoid certain federal regulations as well as applicability of the Uniform Commercial Code. The financial markets, moreover, had become accustomed to using repos instead of formal loan agreements. Repos served several purposes. Among the most significant drivers of the repo market was the Federal Reserve Bank’s requirement that member banks maintain certain percentages of their deposits as reserves, meaning uninvested funds. Sometimes a member bank would not have sufficient reserves and would therefore need to borrow funds from another bank to meet the federal requirements without having to sell off securities from its portfolios. Additionally, repos allowed member banks with capital in excess of the reserve amounts to make profits from those funds that would otherwise be idle. Because repos often served short-term purposes, the agreements were typically of short-term durations as well, often overnight. The collateral exchanged in a repo often consisted of government and agency securities. The advantage of using this form of collateral was that the risk of the issuer dishonoring the interest obligation was considered nonexistent. Moreover, many such debt securities could be transferred through simple bookkeeping entries at the Federal Reserve, making it possible for the repos to take place quickly. Outside of member banks, various large corporations and state and local governments also served as lenders in the repo market. These entities sometimes had large quantities of cash on hand. Instead of holding that cash in checking accounts in which the cash generated no profit, those entities could use repos as short-term and highly liquid investments to earn good returns. There was some risk in the repo market. For example, if the collateral was made up of government or agency debt, an increase in interest rates could cause a decrease in the value of the collateral. This would often require the borrower to post additional collateral. Furthermore, because repos could be entered into by borrowers in conjunction with leveraged investments, the consequences of changes in interest rates could be more drastic, affecting institutions.