Did you miss the days of reckoning on Wall Street in mid-September? You may have heard in passing about a crash in the repo market when rates skyrocketed from 2% to as high as 10%, and the fed funds rate jumped five basis points above its target range. Why does it matter? Repo markets are critical to the survival of Wall Street, as investment houses and banks offer Treasurys as collateral to raise cash overnight to fund their trading and lending activities. A day later, borrowers repay the loans plus a nominal rate to repurchase the bonds. It is a technical play executed by the big boys.
On that brisk early-autumn day, there were not enough reserves or cash in the system to lend out, prompting the repo rate to surge. Desperate institutions were forced to pay higher fees to meet their obligations. But why did this happen?
According to a new study by the Bank for International Settlements (BIS), the repurchasing crash occurred because of the consternation of financial institutions about lending cash and the demand by hedge funds for secured funding. Researchers refrained from naming the banks.
The big banks prefer to store their money at the Federal Reserve to earn the 1.55% in interest instead of the repo market. The report noted that they ostensibly possess enough reserves to meet regulatory guidelines.
The study conceded that the exact cause of the repo upheaval is still unknown. However, it posited a variety of contributing factors, such as immense withdrawals for quarterly tax payments and a greater dependence on the leading banks to keep the repo flowing. In the end, it’s difficult to pinpoint a moment that explains the surprise repo chaos.
What we do know is that there is some justified pearl-clutching over the Federal Reserve injecting the short-term repo lending market with more than $320 billion in cash. The bailout intervention, meant to be only a couple of days, has turned into a three-month affair. It is evident the central bank still has not figured out the issue, choosing to throw money at the $1 trillion mechanism.
Although the Fed’s interventions may have calmed Wall Street, the Eccles Building has not solved anything. It has only compounded the problem because, now that banks have quick and easy funding, they can take their time in funding each other. In other words, the Fed is not allowing things to return to the way they were, which could lead to additional spikes in short-term lending rates.
A Financial Crisis in the Making?
Was the repo market chaos just a case of the Treasury selling securities at the same time corporations were making their quarterly tax payments? Or was there something below the surface to cause alarm?
Talk on The Street suggests there could be serious trouble brewing.
Jamie Dimon, the CEO of JPMorgan Chase, warned that the turmoil unfolding in money markets may be the beginning of a much larger crisis in the financial system. At an Institute for International Finance (IIF) discussion in Washington, Dimon stated that regulations tying up banks’ additional cash stationed at the Fed restricts lenders from extending short-term funding to a broader market. Once institutions reach their repo limit, they cannot deploy further liquidity, which, he contends, could impact the overall $4 trillion in liquidity.
Dimon’s words were reiterated by Randal Quarles, the Fed’s chief on banking supervision. He believes that regulations in place “may have created some incentives” that added to the repo funding madness. If the Fed is willing to offer 1.55%, then why wouldn’t banks take it? If that is the case, then perhaps the Fed might be paying too much.
Whatever the case may be, the Fed’s printing press is working overtime. Not only is it participating in daily liquidity auctions to the tune of $45 billion, but also the central bank is acquiring approximately $60 billion in Treasury bills every month. Despite gradually winding it down, the Fed is placing the balance sheet in expansion mode. Should a financial crisis unfold in the coming years, how could the central bank intervene without setting off an inflation bomb?
Pass the Printing Press Ink
The repo market is where the big boys come to play. It is a highly technical component of the vast financial ocean. You are more likely to talk about quantum field theory around the dinner table than you are about overnight lending markets. Right now, the subject is confined to bankers, traders, and central bankers. However, if this metastasizes into a creature from the black lagoon, it might make stock and bond trading and credit lending more difficult. For an economy that depends too much on the flow of credit, it might be time to become acquainted with all things repo.
Read more from Andrew Moran.