The Repo Market And Our Broken System

Repo Market Bailout

In mid-September 2019, overnight money market rates spiked and exhibited significant volatility, amid a large drop in reserves due to the corporate tax date and increases in net Treasury issuance. Although some upward pressure on money market rates due to these seasonal factors was expected, the extent of the increase in both the level and volatility of rates in secured and unsecured markets was surprising. In this note, we review the money market events of September 2019 and discuss the factors that may have contributed to the sharp rate movements in the repo market and the associated pressures in the fed funds market. This tool can also be used to stabilize interest rates, and the Federal Reserve has used it to adjust the federal funds rate to match the target rate. The Fed was certainly fretting about control over its monetary policy. The Fed has a target range for the federal funds rate, an overnight rate at which banks borrow from each other. Via this market, the Fed’s monetary policy is supposed to be transmitted to the repo market and other short-term credit markets.

Previously, banks were reluctant to apply there because the interest was at a penalty rate and carried a stigma, signaling that the bank must be in distress. But that concern was eliminated when the Fed announced ina March 15 press releasethat the interest rate had been dropped to 0.25% .

The 2008 Crisis: Was It Traditional Banks Or Shadow Banks?

The problem was that the collateral could be “rehypothecated,” or used for several loans at once; and by September 2019, the borrower side of the repo market had beentaken over by hedge funds, which were notorious for risky rehypothecation. Many large institutional lenders therefore pulled out, driving the cost of borrowing at one point from 2% to 10%. Most experts blame quarterly tax payments made by many banks as well as auctions of new Treasury securities by the government, which soaked up cash. The reserve shortfall caused rates to spike in several short-term funding markets. If it continued, such spikes could offset the Fed’s efforts to keep interest rates low. Banks, a small but growing lender in the triparty repo market, also did not increase lending over these few days.3 Increased uncertainty and the temporary nature of the rate spike likely contributed to banks’ reluctance to increase their lending of excess reserves.

The moves in both secured and unsecured rates on September 16 and 17 were much larger than any of those observed over the past few years. Figure 1 shows the effective federal funds rate and the secured overnight financing rate , a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, since December 2015.

Board Of Governors Of The Federal Reserve System

The Federal Gov’t, thru Freddie and Fannie is the market for most of the mortgages being originated today. This has been the case for the last 11 years, ever since the 2008 blowup. Gov got to hold the bag, nobody else wanted exposure to the next 2008. Remember that the Fed is composed of the Member Banks, and JPM is, by far, first among equals. That ZH article also said that JPM has been rotating out of cash and loans and into “long-dated bonds”. The article also said that JPM was planning to distribute $32B in dividends to stockholders (the entire year’s profits), and so needed cash to do that job as well. With rehypothecation, you never really know just how good that “secured” collateral is.

And during a recession, that can be the difference between a firm staying afloat — meaning workers still get their paychecks — or ultimately failing. The Fed’s repo operations led to the balance sheet growing in size again, recovering about half of what it initially sold off. All in all, the Fed took about a trillion dollars out of the system. The repo market’s dysfunction showed that officials might’ve taken the process too far. Fed researchers surveyed major financial institutions to determine what level of reserves would be enough to be considered “ample,” but nobody knew for sure just how many reserves needed to stay in the system.

Lennar Corp Tops Estimates As Low Rates Drive Housing Sales

Earlier this month, the New York Fed injected another $56.7 billion into the repo market in an effort to keep fed funds interest rates in-line with the Fed’s target range of between 1.5% and 1.75%. The Fed also said its balance sheet grew from $3.8 trillion in September to $4.17 trillion by the end of 2019. The Fed is reportedly considering completely overhauling the current repo market and instead begin allowing the repo market clearinghouse, the Fixed Income Clearing Corp. , to lend directly to small banks and hedge funds. This change would essentially eliminate the larger bank middlemen from the process and provide a direct source of overnight loans for small banks. When the value of homes collapsed, this triggered uncertainty in the value of the securities that were collateralizing loans, which led to higher and higher repo rates. All of this caused the banking system to seize up, which turned a housing price crisis into a banking crisis, which then started to spill over into the real economy until the Fed came in and essentially insured everything.

Then, in response to the economic threat from the coronavirus, it led U.S. central bankers to drop a bazooka in March — a series of short-term loans totaling $1.5 trillion. Federal Reserve Chair Jerome Powell and New York Fed President John Williams, in a letter to Rep. Patrick McHenry (R-NC), said the Fed will continue to review a wide range of factors, including supervisory expectations regarding internal liquidity stress tests. Wall Street On Parade has written more than three dozen articles on this critical topic.

Pirates Abound In Unwatched Waters

QE added massive quantities of credit to financial markets to combat the 2008 financial crisis. The Fed could use reverse repos to make adjustments to the short-term securities market. If repo rates spike to 5% or 10%, as they did, suddenly a company like this loses money. And if the repo market counterparties are unwilling to play this game, then any company in this boat would suddenly no longer be able to fund its operations and its leveraged bets, and all heck could break loose. A company borrowing in the repo market to fund long-term investments could blow up in no time.

  • Treasury Bills, effectively creating a new round of Quantitative Easing (QE-4) – a tactic it has not used since the financial crisis.
  • Both broad market trends, as well as specific trading dynamics in different segments of the repo market appeared to play a role in the dynamics observed in mid-September.
  • After much beating around the bush, Mnuchin finally admitted that only about a dozen people work for F-SOC – the Federal agency that is supposed to be the alarm siren for dangerous risks to the U.S. financial system.
  • For the period ended June 30, the company paid an weighted average interest rate of 2.6% on $86 billion in borrowings.
  • A new facility would “likely provide substantial assurance of control over the federal funds rate,” Fed staff told officials, whereas temporary operations would offer less precise control over short-term rates.
  • Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold, at the maturity date.

The value of the collateral is about 2%-3% greater than the cash it receives. That’s the profit to the money market fund for “lending” its cash. What has been suggested by ZH, the Fed and myself — and was confirmed by Dimon himself — was that JPM’s role that it failed to fulfill was on the lending side to the repo market. It didn’t lend to the repo market when everyone thought it would lend to it as repo rates shot up.

What Else Is The Fed Considering?

But other financial firms rely much more on the repo market to fund their speculative bets – and here we’re talking about hedge funds, private equity firms, Real Estate Investment Trusts, and others. One, it’s once again actively intervening in the repo market mostly by buying Treasury securities and mortgage-backed securities.

AGNC lists $106 billion in total assets on its 10-Q filing with the SEC. Of them, about $93 billion are mortgage-backed securities guaranteed by Fannie Mae, Freddy Mac, and Ginny Mae. The second largest asset are about $9 billion in receivables from reverse repos. Plus, it shows $1.2 billion in Treasury securities, and some other things in smaller amounts.

The second example of transactions is between primary dealer bank A and a hedge fund. The red house represents the Federal Reserve’s balance sheet with its assets and liabilities. On the asset side, they usually have treasuries and mortgage-backed securities.

Everything You Have Been Told About Money Creation Is Wrong!

When the government runs a budget deficit, it borrows by issuing Treasury securities. The additional debt leaves primary dealers—Wall Street middlemen who buy the securities from the government and sell them to investors—with increasing amounts of collateral to use in the repo market. While proponents of the potential changes argue it would add liquidity and transparency to the repo market, opponents are concerned the changes would be seen as the Fed giving the green light to hedge funds to increase their leverage and make risky bets.

“These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak,” the New York Fed said in a statement on Thursday afternoon. They found it in gold which almost doubled in value during the most punishing years of the financial crisis from 2007 to 2012. If the business goes on at the present rate… the repo bailout will exceed $29 trillion by June. The next day the borrower “repurchases” the collateral it originally put up… and returns the borrowed money . It holds up high-grade securities such as Treasury bonds as collateral. Board of Governors of the Federal Reserve System The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. What it really boils down to is the Fed would be the only one that was stupid enough to take that collateral that really wasn’t the bank’s to begin with.

On the liabilities side , there are the deposits from the banks under the feds umbrella, typically the primary dealer banks. Also on Twitter, during the month of March, a couple of people asked me this directly, and I responded by saying that I didn’t think the interest rate drop would relieve any of the pressures on the repo market.

Silent Bailouts: How The Federal Reserve Avoids Financial Panics

Other big banks might have had the same problems on the lending side. What we don’t know is what was going on the borrowing side of the repo market. Why would two parties want to participate in a process as antiquated as the repo market? Financial firms with large pools of cash would prefer to not just let that money sit around — it doesn’t collect interest, meaning it doesn’t make any money. On the other side, it allows financial institutions to borrow cheaply to fund short-term needs. To further illustrate just how important it is, the repo market has demanded Fed action for more than seven months now. It first caught the Fed’s attention last fall, after a technical glitch caused short-term interest rates to surge well above the Fed’s target range.

On Monday, September 16, SOFR printed at 2.43 percent, 13 basis points higher than the previous business day. With pressures in the repo market spilling over into the fed funds market, the EFFR printed at 2.25 percent, 11 basis points above the Friday print and at the top of the FOMC’s target range. On September 17, the EFFR moved above the top of the target range to 2.3 percent and the SOFR increased to above 5 percent. If the Wall Street banks making these loans to highly-leveraged hedge funds were partnerships risking their own capital, or even investment banks risking their shareholders’ capital, that would be one thing. But under today’s nightmarish structure on Wall Street, the banks making these risky loans to hedge funds also own large federally-insured commercial banks that are backstopped by the U.S. taxpayer.

The Repo Market Is So Broken That The Fed Wants To Change It

A repo is technically a single transaction whereas a sell/buyback is a pair of transactions . A sell/buyback does not require any special legal documentation while a repo generally requires a master agreement to be in place between the buyer and seller (typically the SIFMA/ICMA commissioned Global Master Repo Agreement ).

As part of our core mission, we supervise and regulate financial institutions in the Second District. Our primary objective is to maintain a safe and competitive U.S. and global banking system. See the world’s largest accumulation of gold as you learn about the New York Fed and Federal Reserve System on a free tour. The latest Annual Report chronicles the impact of Federal Reserve policies and includes data on the New York Fed’s operations. Such a permanent financing program will allow eligible participants to exchange their bonds for cash at a set interest rate.

That’s the main reason why the Fed’s repo operations are so important. When credit dries up, it makes it harder for businesses and firms to get access to a much-needed loan.

The Federal Reserve ramped up the amount of cash it’s prepared to inject into funding markets over the next month, promising a cumulative total above $5 trillion, in a signal that officials will do whatever it takes to keep short-term financing rates from spiking. But unlike in Canada, where big banksslashed their credit card interest ratesto help relieve borrowers during the COVID-19 crisis, US banks did not share this windfall with the public. Canadian interest rates were cut by half, from 21% to 11%; but US credit card ratesdropped in Aprilonly by half a percentage point, to 20.15%. The giant Wall Street banks continued to favor their largest clients, doling out CARES Act benefits to them first, emptying the trough before many smaller businesses could drink there. While the Trump administration dithers and argues with Congress and trips over its own feet, the Federal Reserve has moved decisively to counteract the economic impacts of the coronavirus.

The Fed announced it would start buying T-bills on Oct. 11, 2019. Stocks have gone a tear since… 9% of the stock market’s gains came after Oct. 11, when the Fed announced its T-bill purchase problem.

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