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A Larry Kudlow piece today contained an analogy by one of the guests that was just perfect: He mentioned that Repos (aka Repurchase Agreements) are basically like the Fed acting as a pawn broker for the banks. And he’s exactly right. Here’s how it works…

Bubba Has A Liquidity Crisis

When one of my redneck buddies blows too much of his pay on beer and fried chicken, he sometimes runs a little short on cash for the routine stuff. You know, like rent and electricity. So he takes an asset, say the wife’s wedding ring, down to the pawn shop on Texas street, and the guy behind the counter gives him a few hundred bucks.

Bubba’s a good guy at heart, so he uses that cash to pay the rent or buy the groceries. Then when he gets his paycheck on Friday, he heads back down to the pawn shop and pays the broker the cash back, plus a little interest, of course, and brings honey’s ring back home. All is well, at least for the moment.

Banks Are Bubbas Too

What has been happening the last few weeks is that banks (redneck beer-bellies that they are) have been having trouble meeting their own financial obligations because no one wanted to pay the asking price on some assets they were trying to sell. What assets? Subprime mortgage paper- the notes that amount to I.O.U.’s from millions of our irresponsible neighbors who got into houses they couldn’t afford.

Well, if the Fed just stood by and let the banks look at their creditors (ironically enough, often that’s each other) with a big blank stare and a hangover, things would get really ugly really fast. Banks would begin to default on their obligations and the domino effect would crash the entire economy, possibly in a matter of days.

So, Uncle Ben Bernanke straightens his “Cat Diesel Power” cap, spits some Skoal juice into his ever-present styrofoam cup, and steps up to the pawnshop counter to save the day.

So far, what we’ve described is your normal, everyday overnight repo operation. “Repo” is the nickname for Repurchase Agreements, which simply means the Fed maintains liquidity by loaning the banks cash with some asset as collateral, and the banks then repurchase those assets in the designated time (hence the name- overnight repo, 3-day repo, 14-day repo, etc). This is how Repos differ from other Open Market Operations where the Fed purchases treasuries to permanently add cash to the system… repos add cash temporarily, then take it back, just “keeping the wheels greased,” so to speak, no net long-term change in the overall money supply.

Sounds familiar, no? That’s exactly what the pawn broker does for Bubba. He enters into a repurchase agreement with him for the wife’s ring.

Good Money for Questionable Collateral

But here’s the crucial difference with the Fed’s recent actions: they have agreed to take the unwanted subprime paper as collateral on the repo loans. Typically they would be getting Treasury notes as collateral. Imagine the pawn broker giving Bubba the cash loan and taking as collateral Bubba’s used wristwatch, which was valuable once upon a time, but no one wants it now because Bubba’s been wearing it while he replaced timing chains and camshafts, and it’s all banged up.

The pawn broker would have to be pretty worried about Bubba’s financial state to take a risk like that, wouldn’t he?

The Federal Reserve is providing tens of billions of dollars in liquidity to keep the banking system functioning, and is accepting moldy subprime paper (aka Mortgage Backed Securities) as collateral without significantly discounting those securities (it wouldn’t be as big a deal if the Fed were loaning, say, 40 cents on the dollar for the value of these notes).

That tells you how worried Uncle Ben is about the banks and their liquidity problem. And that’s the real news.