Repo Handbook

The Repo Market - A Handbook for Investors
The Repo Market:

A Handbook for
Investors
Salomon Smith Barney is a service mark of Smith Barney Inc. Smith Barney Inc. and Salomon Brothers Inc are
affiliated but separately registered broker/dealers under common control of Salomon Smith Barney Holdings Inc.
Salomon Brothers Inc and Salomon Smith Barney Holdings, Inc. have been licensed to use the Salomon Smith Barney
service mark. This report was produced jointly by Smith Barney Inc. and Salomon Brothers Inc and/or its affiliates.
Repo Handbook 08/22/00 4:40 PM P.1 SALOMON SMITH BARNEY

TABLE OF CONTENTS
1. Repurchase and Reverse Repurchase Agreements

• Introduction
2. The Repurchase Agreement as an Investment
• Flexibility of the Instrument
• Collateral Alternatives
• Delivery Alternatives
• Repo Math and Convention
3. Reverse Repurchase Agreements

• Introduction
• The General Collateral Market
• The Special Issue Market
• The Mortgage Reverse Market
4. Arbitrage Opportunities in the Repo Market

• Intermarket Arbitrage
5. Reverse Repurchase Mathematics Explained

• Reverse Repo
• Borrow vs. Pledge
• Borrow vs. Cash
6. Historical Perspective & Regulatory Environment

• Resolving the Credit Issues
• Regulatory Framework
7. Appendix
• Third Party
• Glossary of Terms

SECTION 1
REPURCHASE AND
REVERSE REPURCHASE AGREEMENTS
- INTRODUCTION

REPURCHASE AND REVERSE REPURCHASE AGREEMENTS
INTRODUCTION
This handbook serves as an introduction to repurchase agreements (“repo”) and

discusses the range of opportunities currently available to participants in the repo
market. In addition, it attempts to clarify the mechanics, mathematics, terms and
conventions of repurchase agreements.
For those not already familiar with the fundamentals of repurchase agreements, the
following illustrations review the two basic types of transactions; repos and reverse
repos.
1. Repurchase Agreement
A repurchase agreement is a money market transaction in which one party sells

securities with a simultaneous agreement to buy them back at a later date at the
same price plus interest on the sale proceeds, at an agreed upon interest rate.
DAY 1
MONEY
Salomon Brothers Inc

or Smith Barney Inc COLLATERAL
INVESTOR
DAY 2 MONEY
+ REPO INTEREST
or Smith Barney Inc INVESTOR
COLLATERAL
The buyer of the securities invests money for a set term at an agreed upon interest
rate; the “repo rate”. Since the investor receives securities as collateral, the investor
is making a secured investment.
Market convention looks at repo transactions from the dealer's perspective;

therefore, in a repo, the dealer sells securities to an investor who wants to invest
money for a stated length of time. Since a repo agreement is a negotiated
transaction, it can be structured for almost any length of time ranging from overnight
to 10 years.
While, customers can use repo to invest cash or enhance the returns on their
portfolio, it is the principle mechanism that dealers use to finance long positions and
cover shorts.

2. Reverse Repurchase Agreement
In a reverse repurchase agreement ("reverse repo") the dealer buys securities from
the investor with a simultaneous agreement to sell them back at a future date. The
investor borrows money from the dealer at a negotiated rate; the “reverse repo rate”.
DAY 1
COLLATERAL

or Smith Barney Inc MONEY
INVESTOR
DAY 2
COLLATERAL
or Smith Barney Inc MONEY
INVESTOR
+ REVERSE REPO INTEREST
The reverse repo rate will vary depending upon several factors. They include the
type, quality, size and amount of securities purchased as well as the maturity of the
transaction and credit quality of the counterparty.
Whether using this transaction for an individual security or an entire portfolio, reverse
repo provides investors with the ability to generate short term liquidity for a broad
range of collateral types.

SECTION 2
THE REPURCHASE AGREEMENT AS AN

INVESTMENT
- FLEXIBILITY OF THE INSTRUMENT
- COLLATERAL ALTERNATIVES
- DELIVERY ALTERNATIVES
- REPO MATH AND CONVENTION

THE REPURCHASE AGREEMENT AS AN INVESTMENT
As a negotiated instrument, a repurchase agreement is one of the most flexible

short-term investment alternatives available.
FLEXIBILITY OF THE INSTRUMENTS
Virtually all aspects of a repo transaction are negotiated. This enables investors to
tailor each transaction to meet their own specific needs. Investors can choose any
combination of the following.
TERM - The market ranges from overnight out to several years, with the
largest concentration of transactions maturing in three months or less.
Trades can settle for cash (same day) or any future date, and mature on any
date specified by the investor. The term will effect the rate paid. Based on
market sentiment.
COLLATERAL - Repo collateral ranges from US Treasuries and Agencies to

whole loans. The largest repo market is the US Treasury market, followed by
agency debentures and mortgages (GNMA, FNMA, FHLMC).
For further information regarding the types of repo collateral, please see the
section entitled “Collateral Alternatives”.
DELIVERY - An investor has a range of delivery alternatives.
I. Delivery,
II. Third Party,
III. Letter
The delivery mechanism selected also effects the repo rate. Delivery repo
commands a lower rate because of the operational expenses incurred while
letter repo commands a higher rate due to the minimal operational expenses
and increased flexibility provided to dealers in assigning collateral. Each
method is discussed further in the section entitled “Delivery Alternatives”.
RATE - A repo is normally quoted at a fixed rate, for a fixed term, on a CD-
equivalent basis (360 day year). However, a repo can also be quoted on a
discount or floating-rate basis.
In a floating-rate repo, an investor can choose an index (i.e., Fed Funds,

Treasury bills, LIBOR) and receive a spread above or below that index for a
specified period of time resetting with the same frequency as the index.
INTEREST - It is standard to have interest paid at maturity. However, for

longer term trades, investors may choose to receive interest at more frequent
intervals.
MARGIN - Market convention provides for a varying margin percentage

based on the type of collateral.

COLLATERAL ALTERNATIVES
A broad range of collateral alternatives is available to the repo customer. Although

the repo rate largely depends on the type of collateral accepted, the following is a
partial list of factors that effect the repo rate.
- Type of instrument (e.g.: US Treasury or whole loan),

- Form of collateral (physical or wireable),
- Method of delivery (delivery, third-party or letter),
- Size of transaction, and
- Size of collateral pieces.
The table below provides a general description of the various collateral alternatives
available.
US Treasuries Direct obligations of the US Treasury. (Bills,

Notes, Bonds and Strips).
Agency Debentures Notes and bonds issued by agencies of and
corporations created by the US Government,
such as the Federal Farm Credit Banks,
Federal Land Banks, Federal Home Loan
Banks, Student Loan Marketing Association,
Financing Corporation, World Bank and
Resolution Funding Corporation.
Agency Pass- Mortgage-backed securities issued by the
Throughs Government National Mortgage Association
"GNMA", Federal National Mortgage
Association "FNMA" and the Federal Home
Loan Mortgage Corporation "FHLMC".
Agency CMOs A CMO (collateralized mortgage obligation) is
a mortgage backed bond which segments the
cash flows of a pool of mortgage securities.
The mortgage securities are placed in a trust
as collateral for the bonds issued. The CMO
structure represents two or more classes of
debt, called tranches, which pay principal
sequentially and interest continuously. They
are also know as "Agency Remics".

Private Label AAA Private Label CMOs are issued by thrifts or

CMOs and AA & AAA banks. In most cases they are usually
Pass-throughs backed by government guaranteed or top-
grade mortgages and rated AAA by the rating
agencies. Pass-throughs represent a pro
rata interest in a pool of loans. Pass-
throughs provide for monthly payments of
both principal and interest according to a
standard amortization schedule, in addition to
any pre-payments.
Investment Grade Debt instrument issued by a private
Corporates corporation, as distinct from one issued by a
government agency or a municipality. They
are rated AAA to BBB-.
Asset Backs Bonds and notes backed by loan paper or
accounts receivable (non mortgage collateral)
generally originated by banks and credit card
companies. Types of asset backs represent
assets such as auto loans or student loans.
High Yield Debt instrument issued by a private
Corporates corporation having a rating of BB+ or lower.
Eurobonds US dollar or non-dollar bonds denominated in

a currency other than that of the country of
issuance. They provide an important source
of capital for multinational companies and
foreign governments.
Sovereign This may include Japanese Government
Securities Bonds, Canadian Bills, Canadian Bonds,
German Bunds, French Government Bonds
or any bonds issued by a sovereign entity.
Whole Loans Whole loans consist of 100% legal or
beneficial interests in loans secured by
mortgages on real estate, usually residences.
For each loan, Salomon Smith Barney holds
either: (1) a receipt from a custodian bank
holding the loan documents on our behalf,
where the loan note and mortgage is
recorded in our name or the name of the
custodian or its nominee or accompanied by
unrecorded assignments to us or them in
blank; or (2) a participation certificate
representing 100% beneficial ownership of
the mortgage loan.

DELIVERY ALTERNATIVES1
The delivery method selected may influence the repo rate paid on the investor’s
cash. Letter and Third Party Repo will have a rate advantage over Delivery Repo
due to the decreased operational expenses and the increased efficiency of assigning
the repo collateral in a third party account.
Cash and Collateral Move
DELIVERY - A repo in which the
securities are delivered to the investor's Dealer’s Investor’s
Clearance Bank Clearance Bank
clearing bank.
THIRD PARTY - A repo in which the

dealer arranges for the client to open a
separate account at the clearing facility Dealer Investor
where the dealer clears the requested
securities. Delivery of the securities is Collateral
made to this account.
Cash
The repo is collateralized from the pool Cash
of collateral that remains after the
completion of the day's deliveries. The Investors
investor receives either a hard copy or Collateral
an electronically transmitted confirm
detailing the specific collateral and Third Party
market value from both the dealer and Agent
the clearing bank.
(For more information regarding Third Party repo, please see the Appendix entitled
“Third Party” at the end of this document).
LETTER - A repo in which the assigned

collateral consists of physical securities Cash
Investors
at the dealer's vault in a general Collateral
segregation account or at one of the Investor
dealer's clearing banks, or of book entry Dealer
securities at clearing banks and clearing
corporations.
The New York Stock Exchange requires that all repo investors sign the PSA Master
Repurchase Agreement when entering into a letter repo trade with a broker-dealer.
A form of letter repo is safekeep repo. In a safekeep repo, the specific securities
held as collateral for the benefit of the investor does not change without the client's
prior notification. Alternatively, in a letter repo transaction, while the type of collateral
provided remains the same, the specific securities within the collateral pool may be
reassigned daily and does not require the client to be notified of any specific security
substitution.
1 Due to the nature of some collateral types, not all delivery alternatives may be available.

REPO MATH AND CONVENTION

DAY 1
MONEY
S a lo m o n B r o th e rs In c
o r S m ith B a rn e y In c
IN V E S T O R
U S T re a s u ry (6 1 /8 o f 1 1 /1 5 /2 7 )
MONEY
DAY 2 + R E P O IN T E R E S T
S a lo m o n B r o th e rs In c
o r S m ith B a rn e y In c IN V E S T O R
U S T re a s u ry (6 1 /8 o f 1 1 /1 5 /2 7 )
1. CLIENT INVESTS: $10 million for 30 days at a rate of 5.50%.
2. INVESTOR RECEIVES: Collateral: 9,810M of US 6 1/8% of 11/15/27

Collateralized at 102%
Full Price = 104 (Bid Price + Accrued Interest)
CALCULATION OF COLLATERAL AMOUNT:

Collateralization % x Amount Invested = Collateral
Full Price of Collateral Par Amount2
1.02 x $10,000,000 = 9,810M

1.04
3. INVESTOR EARNS: $45,833.33 in repo interest after 30 days.
CALCULATING REPO INTEREST:

Repo Rate Invested x Dollar Amount x Days Held = Repo Interest
360
5.50% x $10,000,000 x 30 = $45,833.33

360
4. AT MATURITY: The investor redelivers collateral to dealer versus

$10,045,833.33.
Original Amount Invested $10,000,000.00

+ Repo Interest + 45,833.33
Amount Paid at Maturity $10,045,833.33
2 Market convention is to round up to the nearest 5,000 par.

SECTION 3
- INTRODUCTION
- THE GENERAL COLLATERAL MARKET
- THE SPECIAL ISSUE MARKET
-THE MORTGAGE REVERSE MARKET

INTRODUCTION
A reverse repo is the converse of a repo and offers portfolio and liability managers
many of the same advantages that a repo offers dealers. Institutions who own
securities can finance, or lend, them through the reverse repo market. The same
rate tiering exists in the reverse market as in the repo market.
There are two distinct reverse repo markets:
(1) General Collateral (“GC”) Market: Provides opportunities for investors to

reverse their general non-specific
securities to Salomon Smith Barney.
(2) Specific Issue (“Specials”) Market: Salomon Smith Barney or the investor
designates specific US Treasury issues
that it would like to borrow or reverse,
respectively. When a particular issue is
in high demand, holders of that issue can
benefit from interest rates that are
substantially below regular overnight
government reverse repo rates.
Whether participating in either the General Collateral or the Specific Issue Market,
an investor can lend US Treasury securities in one of three ways.
Each of the three lending alternatives is illustrated and briefly discussed below.
(A ) REVERSE REPO
DAY 1
COLLATERAL
Salomon Brothers Inc INVESTOR

MONEY
or Smith Barney Inc
DAY 2
COLLATERAL

or Smith Barney Inc MONEY INVESTOR
+ REVERSE REPO INTEREST
In a reverse repo transaction, the client delivers securities to Salomon Smith Barney
versus cash payment. The client pays a rate of interest on the borrowed money; the
reverse repo rate. At maturity, the securities are returned versus cash payment,
including reverse repo interest.

(B) BORROW VS. PLEDGE
DAY 1 BORROWED COLLATERAL

or Smith Barney Inc PLEDGE COLLATERAL INVESTOR
FEE
DAY 2
BORROWED COLLATERAL

or Smith Barney Inc PLEDGE COLLATERAL
INVESTOR
BOTH SIDES OF TRANSACTION VS. MONEY
In a borrow versus pledge transaction, the client lends securities to Salomon Smith
Barney versus the delivery of acceptable pledge collateral. Salomon pays the lender
a fee to borrow the Treasuries. The fee paid in this type of transaction depends on
the demand for the particular borrowed security.
This type of transaction benefits entities who may not need to borrow cash and
accrue the interest expense that is associated with a reverse repo transaction.
(C) BORROW VS. CASH

DAY 1
BORROWED COLLATERAL

or Smith Barney Inc PLEDGE MONEY INVESTOR
DAY 2 BORROWED COLLATERAL

+ LOAN PREMIUM
(LOAN PREMIUM = REVERSE REPO RATE)
In a borrow versus cash transaction, the client delivers securities to Salomon Smith
Barney versus a cash payment. At maturity, the securities are returned versus cash
plus a loan premium. The loan premium is equivalent to the reverse repo interest in
a reverse repo.
A borrow versus cash transaction is operationally similar to a reverse repo but is

documented like a borrow versus pledge, utilizing a securities loan agreement
instead of a repo contract. It works as an alternative to a borrow versus pledge
transaction for customers who prefer securities lending rather than reverse repo
documentation and wish to raise cash rather than receive pledge collateral.

THE GENERAL COLLATERAL MARKET
A reverse repo collateralized by US Treasuries provides one of the least expensive

alternatives for raising cash in the short-term market. Funds generated can be used
for a variety of purposes including:
1) Financing outright long positions,
2) Money Market Arbitrage (See Section 4), or
3) Obtaining funds to meet short-term liquidity needs.
The General Collateral Market differs from the Specific Issue Market in that the
investor may lend an entire Treasury portfolio, or only a portion of it, at a rate and
term specified by the investor, regardless of which Treasury issues are held in the
portfolio.
GENERAL COLLATERAL REVERSE REPURCHASE CONVENTION
The general terms and conditions for most General Collateral reverse repo
transactions with Salomon Smith Barney are as follows:
Term: Most often three months or less; however,

a transactions can be structured to fill
terms of 3 months -10 years, according to
investor requirements
Documentation: PSA Master Repurchase Agreement
+Annex I - Supplemental Terms &
Conditions
Interest: At maturity or more frequent intervals
based upon the term of the reverse
Margin Amount: Haircut(a) by type of collateral:
Bills 1/8 pt per month
Notes ¼ pt per month
Bonds ¼ - 3/8 Negot.
STRIPS 1/4 - 3/8 Negot.
Agencies 1/4 - 3/8 Negot.
Mark-to-Market: Daily
Delivery: Delivery versus payment.
Substitution: Permitted
Coupon Payments: Forwarded to original owner
(a)
The haircut is the difference between the market value of the underlying collateral and the dollar proceeds lent on a
reverse repo.

THE SPECIAL ISSUE MARKET
Salomon Smith Barney borrows specific US Treasury issues from lenders on a daily
basis. As soon as a specific Treasury issue is requested, it becomes a special
issue. When a particular issue is in high demand, holders of that issue can take
advantage of very attractive interest rates on the cash proceeds.
The Special Issue Market fluctuates daily as the supply and demand for certain
Treasury issues changes. The "current" issue in a particular maturity range (e.g., the
most recently issued 2, 3, 5, 10 and 30-year Treasury) usually averages the most
attractive basis point spread to general collateral rates. Additionally, the reverse repo
rate can vary substantially within a day on any particular issue.
To illustrate, assume Salomon Smith Barney borrows GC collateral and delivers

cash to the lender at a rate of 5.50%. Alternatively, the borrowing of the current 10
year may command a reverse repo rate of only 4.50%.
The rate advantage gained by lending the special issue is calculated by subtracting
the overnight reverse repo rate for a particular "special" from the general collateral
repo rate on a given day, in this case, 5.50% - 4.50% = 1% or 100 bps.
SPECIAL ISSUE REVERSE REPURCHASE CONVENTION
The general terms and conditions for most Specific Issue reverse or lending
transactions with Salomon Smith Barney are as follows:
Term: Special Issues are generally traded on a

day-to-day basis; however, longer
transactions may be structured depending
upon the demand.
Documentation: - PSA Master Repo Agreement +

Annex I, or
- PSA Master Securities Loan
Agreement

based upon the term of the reverse
Margin Amount: Negotiable
Delivery: Delivery versus payment
Substitution: Not permitted
Coupon Payments: Forwarded to original owner

THE MORTGAGE REVERSE MARKET
The Mortgage Reverse Repo Market provides institutions with a source of financing
and liquidity for a broad range of mortgage securities.
The mortgage reverse market is more complex than the US Treasury reverse market
due to the complexities and wide range of:
1) collateral types (e.g., GNMA, FNMA, FHLMC, CMOs vs. pass-throughs);
2) varying delivery mechanisms;
3) piece sizes;
4) coupons;
5) tranche in CMOs; and
6) issuers.
Collateral: Agency pass-throughs (GNMA, FNMA,

FHLMC), agency REMICS, AA and AAA non-
agency CMOs, AA private label pass-throughs
and whole mortgage loans
Term: Most often 3 months or less; however,

transactions can be structured for longer terms
according to investor’s requirements
Pricing: Market bid prices does not include accrued

interest
Haircut: GNMA,FNMA,FHLMC (including REMICS) =

4 pts/first month, 1 pt/month to a maximum of 7
points;
Non-Agency CMO and AA pass-throughs =
SEC minimum 5 points (range 5-10 points);
Whole Mortgage Loans = 10 points
Delivery: Delivery versus payment
Substitution: Permitted if intention to substitute is indicated

prior to pricing. Without notification, the
requestor may incur an operations expense
surcharge
Coupon Payments Forwarded to original owner

and Prepayments:
Documentation: PSA Master Repurchase Agreement with

Annex 1, Supplemental Terms & Conditions.

SECTION 4
ARBITRAGE OPPORTUNITIES IN THE

REPO MARKET
- INTERMARKET ARBITRAGE

ARBITRAGE OPPORTUNITIES IN THE REPO MARKET
Portfolio investors can augment the return on their existing government investments
by reversing or lending their US Treasury and Agency bonds to Salomon Smith
Barney on a short term basis and investing the proceeds in higher yielding
repurchase agreements.
Assume the reversed or borrowed securities are in blocks of $10MM or greater.
The following grid lists the basis point returns that lenders who lend US Treasuries
or agency mortgages could realize by accepting the listed securities as collateral on
the repurchase.
(Borrow vs. TriParty Pledge or Reverse Repo and Third Party Repo)
Indicative Basis Point Spread3
US TSY AGENCY MTG

Repo Collateral
Asset Backs 8 bp -
Agency MBS and IO/POs 10 bp -
Private Label AAA CMOs 10 bp -
Private Label AA & AAA 10 bp -

Pass-thrus
Investment Grade Corporates 10 bp -
High Yield Corporates 25 bp 25 bp
Brady Bonds4 25 bp 25 bp
Other Emerging Markets4 25 bp 25 bp
Whole Loans
Residential 20 bp 20 bp
Commercial 30 bp 30 bp
The rates listed above assume situations in which a Third Party custody facility is
utilized.
3 Rates are subject to change.

4 Letter, Delivery or Third Party

INTERMARKET ARBITRAGE - Example
1. AT INCEPTION
(a) Investor Reverses Security into Salomon Smith Barney
Amount Issue Price5 Term Rate

10MM Par US 6 1/8% of 11/15/27 104 30 days 5.50%
(b) Investor Receives:
$10,400,000 in cash. (10MM Par x 104 Price)
(c) Investor Reinvests Proceeds in High Yield Corporate Letter Repo
Amount Invested Type of Repo Term Rate

$10,400M High Yield Corporate Letter Repo 30 days 5.75%
2. AT MATURITY
(a) Investor Receives:
Principal invested in repo plus repo interest = $10,049,833.33
Repo Rate x Proceeds x Days Held = Repo Interest

360
5.75% x $10,400,000 x 30/360 =$49,833.33
(b) Investor Owes:
Principal from reverse plus reverse interest = $10,047,666.67
Reverse Rate x Proceeds x Days Held = Reverse Interest

360
5.50% x $10,400,000 x 30/360 =$47,666.67
INVESTOR’S NET EARNINGS
As a result of this arbitrage transaction, the investor is able to lock in 25 bps (5.75% -
5.50%) or $2,166.66 ($49,833.33 - $47,666,67) for a 30 day period.
5 Price = Full Price less haircut.

SECTION 5
REVERSE REPURCHASE MATHEMATICS

EXPAINED
- SPECIFIC ISSUE TRADE SCENARIO TERMS
- SCENARIO 1: REVERSE REPO
- SCENARIO 2: BORROW VS. PLEDGE
- SCENARIO 3: BORROW VS. CASH

REVERSE REPURCHASE MATHEMATICS EXPAINED
SPECIFIC ISSUE TRADE SCENARIOS TERMS
The following four pages detail the mechanics of the three different ways in which a
Specific Issue can be loaned to Salomon Smith Barney:
1. Reverse repo,
2. Borrow vs. pledge and
3. Borrow vs. cash.
Standard terms for all of the trade scenarios are listed below.
Specific Issue Security: US 6 1/8% of 11/15/27
Par Amount: $10,000,000
Cash Settlement of Specific Transaction: Day 1
Maturity of Specific Transaction: Day 2
Full Price of Pledge Collateral: 101
Full Price of Specific Borrowed Security: 103

(Flat Price + Accrued Interest)
Specific Issue Reverse Repo Rate: 4.30%
US Treasury Overnight Repo Rate: 5.50%
Borrow Fee: 120 bp

SCENARIO 1: REVERSE REPO
DAY 1
U S T re a s u ry (6 1 /8 o f 1 1 /1 5 /2 7 )
S a lo m o n B ro th e rs In c
o r S m ith B a r n e y In c M O NEY IN V E S T O R
DAY 2 U S T re a s u ry (6 1 /8 o f 1 1 /1 5 /2 7 )
S a lo m o n B ro th e rs In c
o r S m ith B a r n e y In c M O NEY IN V E S T O R
+ R E V E R S E R E P O IN T E R E S T
DAY 1:
(A) INVESTOR REVERSES SPECIFIC ISSUE INTO SALOMON SMITH BARNEY
Amount Issue Full Price Rate

$10MM Par US 6 1/8% of 11/15/27 103 4.30%
(B) CUSTOMER RECEIVES:
Par Amount x Full Price of Collateral = Dollar Proceeds
$10MM x 1.03 = $10,300,000
DAY 2:
SALOMON SMITH BARNEY RETURNS US 6 1/8% OF 11/15/27 TO INVESTOR

VERSUS ORIGINAL BORROWED AMOUNT PLUS REVERSE REPO INTEREST
Days Held Reverse Repo

Reverse Rate x Dollar Proceeds x 360 = Interest
.0430 x $10,300,000 x 1 = $1,230.28

360
Dollar Proceeds $ 10,300,000.00

+ Reverse Repo Interest + 1,230.28
Amount Owed at Maturity $ 10,301,230.28

SCENARIO 2: BORROW VS. PLEDGE
DAY 1 U S T re a s u r y (6 1 / 8 o f 1 1 /1 5 /2 7 )
S a l o m o n B r o t h e r s In c
o r S m ith B a r n e y In c PLED G E C O LLAT ER AL IN V E S T O R
FEE
DAY 2 U S T re a s u r y (6 1 / 8 o f 1 1 /1 5 /2 7 )
S a l o m o n B r o t h e r s In c
o r S m ith B a r n e y In c
IN V E S T O R
PLED G E C O LLAT ER AL
( B O T H S I D E S O F T R A N S A C T IO N V S . M O N E Y )
DAY 1:
(A) INVESTOR LENDS SPECIAL TO SALOMON SMITH BARNEY VS PAYMENT
Amount Issue Full Price

$10MM Par US 6 1/8% of 11/15/27 103
$10MM x 1.03 = $10,300,000
(B) SALOMON SMITH BARNEY DELIVERS PLEDGE ISSUE VS PAYMENT

$10,405M Par US 5 3/4 of 11/30/02 101
Calculation of Pledge Issue Par Amount:
Proceeds = Par Amount of Pledge Issue6

Full Price of Pledge Issue
$10,300,000 = $10,198 x 1.02% (2% margin) = 10,405

1.01
6 Round up to the nearest 5000 lot.

DAY 2:
(A) SALOMON SMITH BARNEY RETURNS US TREASURY (6 1/8% of 11/15/27) TO

INVESTOR PLUS A BORROW FEE VERSUS PAYMENT OF 10,300,000
The borrow fee is calculated as follows:
Fee x Par Amount x Days Held = Borrow Fee

360
120 bps (.0120) x $10MM x 1 = $333

360
(B) INVESTOR RETURNS PLEDGE ISSUE TO SALOMON SMITH BARNEY
$10,405M Par Amount of US 5 3/4 of 11/30/02 versus payment of $10,300,000

plus the borrow fee of $333 = $10,000,333.

SCENARIO 3: BORROW VS. CASH

US Treasury (6 1/8 of 11/15/27)
DAY 1

US Treasury (6 1/8 of 11/15/27)

DAY 2

or Smith Barney Inc
PLEDGE MONEY INVESTOR
+ LOAN PREMIUM
(LOAN PREMIUM = REVERSE REPO RATE)
DAY 1:
INVESTOR LENDS SPECIAL TO SALOMON BROTHERS VERSUS PAYMENT

$10MM Par US 6 1/8 of 11/15/27 103
$10MM x 1.03 = $10,300,000
DAY2:
SALOMON SMITH BARNEY RETURNS SPECIAL TO INVESTOR VERSUS

PAYMENT OF $10,300,000 AND $1,230.28 IN LOAN PREMIUM.
Loan Premium x Proceeds x Days Held = Loan Premium

360
4.30 x $10,300,000 x 1 = $1,230.28

360
Dollar Proceeds $ 10,300,000.00

+ Loan Premium + 1,230.28
Amount Owed at Maturity $ 10,301,230.28

SECTION 6
Historical Perspective & Regulatory

Environment
- RESOLVING THE CREDIT ISSUES
- REGULATORY FRAMEWORK - WHO REGULATES AND HOW

HISTORICAL PERSPECTIVE & REGULATORY ENVIRONMENT
RESOLVING THE CREDIT ISSUES
A repurchase agreement is essentially two-party paper where the lender has the
credit of the counterparty in addition to the collateral as security. From the
perspective of both the dealer and the investor, counterparty credit is an important
issue. Each entity must assess the credit of its counterparty regardless of the
collateral.
The importance of such an assessment is highlighted by the bankruptcies of several

unregulated dealers that fraudulently used repurchase agreements to hide their
insolvent operations. These incidents have unfairly marred the image of repo as a
flexible and safe instrument. Yet these dealer failures resulted in the correction of
previously unaddressed market weaknesses. As a result, the repo market is now
safer and more closely regulated than ever.
The Drysdale bankruptcy in 1982, the failure of Lombard Wall, also in 1982, and the
bankruptcies of ESM and Bevill Bressler in 1985 are the dealer failures primarily
responsible for bringing about tighter regulations.
Drysdale Government Securities, 1982
In the Drysdale Government Securities bankruptcy, Drysdale took advantage

of the industry’s former and inaccurate practice of pricing US Treasury repo
collateral without taking into consideration the accrued interest on the bonds.
Drysdale sold US Treasury securities with significant accrued interest and, in

turn, borrowed the same securities through reverse repos from entities that
owned them. Drysdale used the difference between the reverse repo value
of the securities (principal amount only) and the selling price (principal
amount plus accrued interest) as capital to finance its operations. Drysdale
continued these practices until the coupon payments, that they were
responsible for passing on to the reverse investors, were due on the bonds.
Declining interest rates resulted in significant losses on these transactions

and, as a result, Drysdale Government Securities defaulted on the coupon
payments.
Regulatory Response
In October 1982, the Federal Reserve, in conjunction with the Primary

Dealers’ Association, successfully established a pricing mechanism for US
Treasury repos which included accrued interest.

Lombard-Wall, 1982
Under traditional bankruptcy law principles, secured creditors of a bankrupt

entity must obtain the permission of the bankruptcy court before they may
liquidate the collateral securing the bankrupt entity’s obligations.
When Lombard-Wall, another unregulated dealer, failed in 1982, it sought to

apply this “stay” rule to its repo customers. The market was rising and the
court soon granted the necessary permission to liquidate. Therefore, there
were no losses.
Regulatory Response
Recognizing that the bankruptcy stay posed a threat to investor liquidity and
raised concern about the adequacy of standard margin practices, the Federal
Reserve Bank of New York and the Public Securities Association sponsored
legislation, enacted in 1984, that created an exemption from the stay rule for
repos, with maturities of up to one year, that were collateralized by
governments, agencies, CDs and BAs.
The legislation did not address the liquidation of banks, thrifts and SEC-
registered broker-dealers, each of which is subject to special bankruptcy
procedures administered by federal government agencies. However, each
of those agencies have stated that they would not stay the liquidation of repo
collateral absent evidence of fraud in the transactions.
ESM Government Securities Inc./Bevill Bressler & Schulman, 1985
The bankruptcies of ESM Government Securities Inc. (Florida) and Bevill

Bressler & Schulman (New Jersey) in 1985 shared common features. Both
ESM and Bevill Bressler were experiencing trading losses, high operating
expenses and fraudulently misrepresented these losses in their financial
statements.
Both firms entered into repo transactions in which the investors were
informed that the collateral underlying the transactions was being held in
safekeep at the firms’ respective clearing houses. These dealers were
double pledging the securities as collateral for loans from the clearing banks
while also using the same securities for repo transactions with more than
one investor. Additionally, reverse repo investors with ESM provided it with
excessive margin. Losses for reverse investors equaled the difference
between the market value of the securities (plus accrued interest) and the
cash received from the reverse.
Regulatory Response
In the aftermath of ESM and Bevill Bressler, market participants have taken
significant steps towards minimizing risks in repo transactions.

In 1985, the Federal Financial Institutions Examination Council (FFIEC) proposed

supervisory policy guidelines addressing such matters as:
1) Adequate collateralization and mark-to-market procedures;

2) Verifiable credit analyses of borrowers;
3) Documentation of repo transactions; and,
4) Internal safeguards and ongoing review procedures concerning repo
agreements. The FRB, FDIC, and FHLBB quickly adopted the FFIEC
guidelines.
In turn, the FRBNY promulgated a 1.2 to 1 liquid capital-to-risk ratio for all
government securities dealers. Enforcement has depended upon market
participants limiting their repo transactions to dealers who conform to the standard.
Meanwhile, investors have actively instituted internal procedures for credit analyses
of government securities dealers.
The development of a standardized written repurchase agreement by the Public

Securities Association (“PSA”) has spurred investors to carefully document trades
and collateral arrangements. All of these initiatives have increased market discipline
and focused attention on the old saying - “Know your counterparty”.
Finally, Congress responded in 1986 with legislation that required registration of all
previously-unregulated government securities dealers subjecting them to regulation
by the US Department of the Treasury. The Treasury has proposed regulations
prescribing minimum capital requirements and mandatory procedures for assuring
the proper safekeeping of customer securities, including those subject to repurchase
agreements.

REGULATORY FRAMEWORK - Who Regulates and How
REGULATOR SCOPE OF REGULATORY OVERSIGHT

US Department of the Regulates the sale (timing, maturity, and auction
Treasury procedures) of US Treasury obligations. Regulates
previously unregistered government securities dealers.
Federal Reserve Bank of Oversees the activities of the primary government

New York (“The Fed”) securities dealers in the following manner:
Daily Basis - government, money market and futures
and options positions.
Weekly Basis - repos, reverses, loans, and matched-
book trading.
Monthly Basis - revenues and net profit by product
areas.
Semi-annual Basis - balance sheet and income
statement.
Securities Exchange Regulates all registered broker-dealers. Government

Commission (“SEC”) securities dealers who also conduct transactions in
corporate or municipal securities must not only register
with the SEC, but must also abide by all recordkeeping,
reporting, and other financial responsibilities.
The New York Stock Enforces various rules that govern repo transactions
Exchange (“NYSE”) conducted by NYSE members.
Comptroller of Currency Regulates national banks.
Federal Deposit Insurance Regulates banks insured by the FDIC.

Corporation (“FDIC”)
Federal Reserve Board Regulates state member banks and bank holding
companies.
Federal Home Loan Bank Regulates savings and loan associations and other
Board (“FHLBB”) thrift institutions.
National Credit Union Regulates credit unions.
Association
US Department of Labor Regulates pension funds.

SECTION 7
APPENDIX
- THIRD PARTY
- GLOSSARY OF TERMS

THIRD PARTY
Third Party is the simplest delivery alternative available for investors who require the
delivery of repo collateral. For Third Party deliveries, Salomon Smith Barney opens
a separate account for the investor at either The Bank of New York or The Chase
Manhattan Bank.
In a Third Party delivery, a custodian will effect the exchange of cash and securities
on the purchase date. The Third Party Custodian only transfers securities that have
been previously deemed acceptable by the buyer into a segregated account in the
name of the buyer. On the repurchase date, the Third Party custodian will again
effect the exchange of securities and cash between the buyer and seller,
respectively.
The Basic Flow of Events for Third Party Repo

(1) The investor deposits cash into a Demand Deposit Account at either The Bank of
New York or The Chase Manhattan Bank;
(2) Salomon Smith Barney then delivers the securities to the investor’s Third Party
account;
(3) The bank then transfers the funds to Salomon Smith Barney.
(At all times, the investor has money or collateral in the account.)
PRICING
The repo collateral is priced daily by both Salomon Smith Barney, using its own bid
prices from the prior night’s close, and the clearing bank.
The Bank of New York uses SST Street Software, Interactive Date Services Corp.
(IDSI), Muller Data service or Bridge Information Services. The Chase Manhattan
Bank uses Interactive Data Services Corp. (IDSI).
COLLATERAL ALLOCATION
Collateral is assigned by the cashiering department at Salomon Smith Barney from
the pool of collateral which remains after completion of the day’s deliveries.
The investor receives a hard copy confirm from both Salomon Smith Barney and the
clearing bank detailing all of the securities held in the account.
ADVANTAGES
• All aspects of the transaction, including acceptable collateral and appropriate

margin, are reviewed by an independent third party.
• The Third Party pricing service determines appropriate prices.
• There is automatic daily mark to market of securities.
• Simultaneous delivery of collateral vs. payment (DVP).

• Reduced administrative effort and reduced collateral delivery problems.

• Continuing checks upon the conformity of the collateral.
• Provides flexibility in timing and amount.
• The investor can choose from a variety of collateral types, including US
Treasuries, Agency debentures and mortgages, CMOs, private label pass-
throughs, asset backs, investment grade and high yield corporates, emerging
market securities and whole loans.
• Third Party repo offers increased yield over standard delivery repo for both
overnight and term transactions.
• For term transactions, the collateral is substituted and repriced daily. This
automatically results in a daily mark-to-market. The investor receives daily
confirmation of all substitutions, including a full collateral listing.
• Salomon Smith Barney absorbs all costs of opening the Third Party account
and collateral movements.
The following diagrams illustrate the general mechanics of a third party facility.
Diagram of Third Party Repo Transaction
Salom on Brothers Inc, or

Sm ith Barney Inc Account Investor
$51MM
B of acceptable A
$50MM repo collateral $50MM
Investor’s Account
at T hird Party Bank
Investor agrees to invest $50MM in Third Party Repo.

A - Investor wires $50MM to their account at Third Party Bank.
B - Salomon Smith Barney delivers $51MM (102%) of acceptable repo
collateral vs. $50MM to Third Party account (simultaneous
transaction).
Investor earns a rate of interest; Repo Rate

Diagram of Third Party Borrow vs. Pledge Transaction
$50MM 6 3/8 of 8/15/27

Salomon Brothers Inc, or
A Investor
Smith Barney Inc Account
$50MM
$51MM
C of acceptable B
$50MM repo collateral $50MM
Investor’s Account
at Third Party Bank
Investor agrees to lend $50MM 6 3/8% of 8/15/27 to Salomon Smith

Barney on Third Party Borrow vs. Pledge basis.
A - Investor delivers $50MM 6 3/8% of 8/15/27 vs. $50MM.

B - Investor wires $50MM to their account at Third Party Bank.
C - Salomon Smith Barney delivers $51MM (102%) acceptable pledge
collateral vs. $50MM to Third Party account (simultaneous
transaction).
Investor earns Basis Point Fee
New accounts are opened within a day or two following the receipt of all
necessary documentation.
All documents can be obtained from and returned to:

Theresa M. Russo (212) 783-3181.

GLOSSARY OF TERMS
BOOK-ENTRY SECURITIES - Also known as wireable securities. They are transferred

from one entity to another through the Fed Wire. US Treasury and Agency securities
including FNMA and FHLMC mortgage-backed securities are book-entry. GNMAs are
wireable through Participants Trust Company’s system.
BORROW-TO-MATURITY - A dealer borrows an issue in which the term of the
transaction extends to the maturity date of the issue.
BORROW VS. CASH - A transaction in which a dealer borrows treasury securities and, in
exchange, pledges cash for which the investor pays a loan premium. The loan premium
corresponds to the reverse repo rate for the particular US Treasury issue.
BORROW VS. PLEDGE - A transaction in which a dealer borrows specific US Treasury
securities and, in exchange, pledges other securities such as general US Treasury
collateral or agency mortgages as collateral and pays the investor a fee.
BUY/SELL - A dealer buys an issue outright and later sells it back to the investor. The
difference between the price paid and the price the issue is sold for is the imputed reverse
repo rate. This is a less common method of borrowing and is mostly used by non-US
counterparties.
CARRY - The spread between the yield on an issue which is owned and the rate at which
money is borrowed to finance that issue equals the cost to "carry" an issue.
COLLATERAL - A term used to identify any securities delivered in a repurchase or
secured loan transaction.
COLLATERALIZATION - The percentage amount of collateral exchanged in a repo
transaction that exceeds the cash dollar amount.
DAY-TO-DAY OR OPEN REPO - A repurchase transaction which does not have a pre-
specified termination date. With an open repo, either the borrower or the investor may
terminate the transaction at any time by "pulling" or "returning" the issue.
DVP - Delivery vs. Payment. In a repo or reverse repo, securities are transferred versus
payment.
FAIL - A failure to deliver securities. The originator of the delivery is held liable.
FED WIRE - Connects the Federal Reserve offices, depository institutions, the US
Treasury, and other government agencies. The Fed Wire is typically used to transfer
large dollar payments and book-entry securities electronically from one institution to
another on behalf of investors.
FREE - Securities which are transferred versus no payment.
HAIRCUT - A percentage of the price of a security used to calculate the margin.
MARGIN - Actual amount of excess collateral securing a reverse or repo by taking a
haircut.
MARK-TO-MARKET - An adjustment in the collateralization of a repo or reverse to
conform to margin requirements. If a party is over or undercollateralized the situation will
be rectified by collateral moving free to the appropriate party.
MONEY WIRE - Like the Fed Wire, it is only used exclusively for transferring dollar
payments. The Money Wire always closes after the Fed Wire.
NEGATIVE CARRY - Where the cost to carry or finance is greater than the yield on a
security.

OFF-THE-RUN - A non-current treasury issue. These issues are less likely to become a
"special".
PARTICIPANTS TRUST COMPANY (PTC) - Clearing Housing for wireable book-entry
GNMAs.
POSITIVE CARRY - Where the cost to carry or finance is less than the yield on a security.
PRINCIPAL VS. AGENT - In a principal transaction, the investor is acting for its own
account. An "agent" acts on behalf of the principal’s (someone else’s) account. In all
repo transactions, the principal must be known in order to avoid credit risk.
PUBLIC SECURITIES ASSOCIATION (PSA) - Is a national trading association that
represents banks, dealers and brokers who underwrite, trade and sell mortgage-backed,
government and municipal securities.
REPO AGREEMENT - A legally binding contract between a purchaser and a seller to
conduct repurchase transactions. The Public Securities Association has created a
standard Repurchase Agreement which minimizes the risk associated with repo
transactions.
REPO - A transaction which includes both the sale and subsequent repurchase of
securities at a specified time and at a specified price. As the "seller" of the securities, the
dealer pays a rate of interest (“repo rate") to the purchaser on the cash.
REVERSE REPO - The reverse of a repurchase transaction. A dealer purchases
securities from an investor and simultaneously agrees to sell them back at a later date.
The dealer provides the investor with cash on which the investor pays a specified rate of
interest ("reverse repo rate"). This is a source of financing for investors.
REVERSE-TO-MATURITY - A dealer purchases an issue on a reverse repo basis. The
term of the transaction extends to the maturity date of the issue.
SPECIAL ISSUE - An issue which is necessary to borrow in order to cover a short sale.
High demand creates a situation where a dealer will reverse in the security at a rate much
lower than the regular reverse repo rate.
SUBSTITUTION - One particular issue is substituted for another in a delivery. On a repo,
this can occur either before or after delivery is initiated. The investor is always informed of
the substitution.
TERM REPO - A repurchase transaction with a specified termination date greater than 1
day.

STANDARD DISCLAIMER LANGUAGE
Although the information herein has been obtained from sources which Salomon
Smith Barney believes to be reliable, we do not guarantee its accuracy, and such
information may be incomplete or condensed. All opinions and estimates included
herein constitute our judgment as of this date and are subject to change without
notice. This material is for information purposes only and is not intended as an offer
or solicitation with respect to the purchase or sale of any security.
This material is furnished on the understanding that Salomon Smith Barney is not
undertaking to manage money or act as a fiduciary with respect to your account or
any of your managed or fiduciary accounts and that our services do not serve as a
primary basis for any investment decision made with respect to such accounts. This
material provides information and/or alternatives which may be appropriate for your
consideration. The decision whether or not to adopt any strategy or engage in any
transaction is not our responsibility.

Smith Barney Inc and Salomon Brothers Inc, 1997 All rights reserved. Any unauthorized use, duplication or disclosure is
prohibited by law and will result in prosecution.

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The Repo Market - A Handbook for Investors

The Repo Market:

Repo Handbook 08/22/00 4:40 PM P.1 SALOMON SMITH BARNEY

1. Repurchase and Reverse Repurchase Agreements

3. Reverse Repurchase Agreements

4. Arbitrage Opportunities in the Repo Market

5. Reverse Repurchase Mathematics Explained

6. Historical Perspective & Regulatory Environment

Repo Handbook 08/22/00 4:40 PM P.2 SALOMON SMITH BARNEY

Repo Handbook 08/22/00 4:40 PM P.3 SALOMON SMITH BARNEY

REPURCHASE AND REVERSE REPURCHASE AGREEMENTS

This handbook serves as an introduction to repurchase agreements (“repo”) and

A repurchase agreement is a money market transaction in which one party sells

Salomon Brothers Inc

Market convention looks at repo transactions from the dealer's perspective;

Repo Handbook 08/22/00 4:40 PM P.4 SALOMON SMITH BARNEY

2. Reverse Repurchase Agreement

Salomon Brothers Inc

Repo Handbook 08/22/00 4:40 PM P.5 SALOMON SMITH BARNEY

THE REPURCHASE AGREEMENT AS AN

- REPO MATH AND CONVENTION

Repo Handbook 08/22/00 4:40 PM P.6 SALOMON SMITH BARNEY

THE REPURCHASE AGREEMENT AS AN INVESTMENT

As a negotiated instrument, a repurchase agreement is one of the most flexible

FLEXIBILITY OF THE INSTRUMENTS

COLLATERAL - Repo collateral ranges from US Treasuries and Agencies to

DELIVERY - An investor has a range of delivery alternatives.

In a floating-rate repo, an investor can choose an index (i.e., Fed Funds,

INTEREST - It is standard to have interest paid at maturity. However, for

MARGIN - Market convention provides for a varying margin percentage

Repo Handbook 08/22/00 4:40 PM P.7 SALOMON SMITH BARNEY

A broad range of collateral alternatives is available to the repo customer. Although

- Type of instrument (e.g.: US Treasury or whole loan),

US Treasuries Direct obligations of the US Treasury. (Bills,

Repo Handbook 08/22/00 4:40 PM P.8 SALOMON SMITH BARNEY

Private Label AAA Private Label CMOs are issued by thrifts or

Eurobonds US dollar or non-dollar bonds denominated in

Repo Handbook 08/22/00 4:40 PM P.9 SALOMON SMITH BARNEY

THIRD PARTY - A repo in which the

LETTER - A repo in which the assigned

Repo Handbook 08/22/00 4:40 PM P.10 SALOMON SMITH BARNEY

REPO MATH AND CONVENTION

1. CLIENT INVESTS: $10 million for 30 days at a rate of 5.50%.

2. INVESTOR RECEIVES: Collateral: 9,810M of US 6 1/8% of 11/15/27

CALCULATION OF COLLATERAL AMOUNT:

1.02 x $10,000,000 = 9,810M

3. INVESTOR EARNS: $45,833.33 in repo interest after 30 days.

CALCULATING REPO INTEREST:

5.50% x $10,000,000 x 30 = $45,833.33

4. AT MATURITY: The investor redelivers collateral to dealer versus

Original Amount Invested $10,000,000.00

2 Market convention is to round up to the nearest 5,000 par.

Repo Handbook 08/22/00 4:40 PM P.11 SALOMON SMITH BARNEY

REVERSE REPURCHASE AGREEMENTS

- THE GENERAL COLLATERAL MARKET

- THE SPECIAL ISSUE MARKET

-THE MORTGAGE REVERSE MARKET

Repo Handbook 08/22/00 4:40 PM P.12 SALOMON SMITH BARNEY

REVERSE REPURCHASE AGREEMENTS

There are two distinct reverse repo markets:

(1) General Collateral (“GC”) Market: Provides opportunities for investors to

Salomon Brothers Inc INVESTOR