As if the U.S. Federal Reserve did not already have enough on its plate heading into its meeting on interest rates this week, chaos deep inside the plumbing of the U.S. financial system has thrown policymakers an unexpected curve ball. When rates on the typically steady overnight re-purchase agreements behave like the stock market, as they did this week, even the broad market pays attention.
But despite the flashing red lights, this increase in short-term rates is being driven by technical factors, rather than credit concerns. The FED made an emergency injection of more than $125 billion over a two-day period, its first major market intervention since the financial crisis more than a decade ago. The exact cause of the stress is a matter of some debate, but the source is well known: the $2.2 trillion repurchase agreement, or “repo” market, a gray but essential component of the U.S. financial system.
Technical factors led to a sudden shortfall of cash in the banking system, and the FED pumped money into the market to keep borrowing costs from creeping above the Fed’s target range. The rate on overnight repurchase agreements hit 5% on Monday, September 16th, according to Refinitiv data. That’s up from 2.29% last week and well above the target range set in July by the Federal Reserve, which is 2% to 2.25%.
The surge continued Tuesday, with the overnight rate hitting a high of 10% before the NY Fed stepped in. Giving this some perspective: if you want to borrow money for 30 years, the US government will give it to you for 2.25%. But if you need to borrow some money for the next 24-36 hours, you’re paying double digits.1
To help rectify this issue, the FED intervened by adding liquidity to the markets, as previously mentioned, in an unrelated move they cut the federal fund’s rate by a quarter point, boosting lender and investor moral, and by cutting the Interest Rate on Excess Reserves (IOER) by 30 basis points.
The IOER was introduced in 2008 as a way to incent banks to maintain a larger basket of excess reserves, so the FED would not have to engage in daily transaction in the money markets. We have enjoyed large amounts of excess reserves ever since. However, since the inception of the IOER we have also seen a lot of regulations put on banks regarding liquidity and capital standards, such as Dodd-Frank. The regulations have been successful at improving reserve levels and capital standards of banks, but they have made it more difficult for the FED to estimate how much money the banks need to meet all their liquidity and regulatory needs. 1,2,3
In this case, some of the technical factors that caused the cash crunch include:
- Payments on corporate taxes were due on September 15th, leading to high redemptions of more than $35 billion in money market funds. 4
- Cash balances increased by an additional $83 billion in the U.S. Treasury general account, which reduces excess reserves and simultaneously acts to reduce the aggregate supply of overnight liquidity available in funding markets. 4
- Dealers needed an additional $20 billion in funding to finance the settlement of recent scheduled U.S. Treasury issuance. 4
- The latest rounds of quantitative tightening saw the FED cull its balance sheet to $1.47 trillion, the lowest level since 2001 and nearly 50% below its peak from five years ago, leaving the opportunity for a liquidity crunch. 3
What is a Repo?
Repos are very short-term collateralized loans.
In a repo trade, Wall Street firms and banks offer U.S. Treasuries and other high-quality securities as collateral to raise cash, often overnight, to finance their trading and lending activities. The next day, borrowers repay their loans, plus what is typically a nominal rate of interest, and get their bonds back. In other words, they repurchase, or repo, the bonds. 2
The system typically hums along with the interest rate charged on repo deals hovering close to the Fed’s benchmark overnight rate. 2
Why is the Repo Market Important?
Although it doesn’t get as much attention as the Dow or the 10-year Treasury rate, this overnight market plays a central role in modern finance. The repo market underpins much of the U.S. financial system, helping to ensure banks have the liquidity to meet their daily operational needs and maintain sufficient reserves.
But when investors get fearful of lending, as seen during the global credit crisis, or when there are just not enough reserves or cash in the system to lend out, it sends the repo rate soaring above the Fed Funds rate. When this occurs, trading in stocks and bonds can become difficult. It can also affect lending to businesses and consumers, and if the disruption is prolonged, it can become a drag on the U.S. economy that relies heavily on the flow of credit. 1,2
Who is involved in the Repo market?
Participation in the repo market is broad. Direct participants include depository institutions like commercial banks, the U.S. government and its agencies, investment funds, primary dealers, money market mutual funds, investment banks, hedge funds, insurance companies, and non-banking financial institutions. Indirect participants include anyone with a loan or mortgage; residential mortgages, auto loans, and credit card loans, etc. The federal government is the only entity with a large enough balance sheet to finance the repo market should liquidity dry up.
A historical perspective
By now, nearly everyone knows that the financial meltdown of 2007/2008, and the subsequent recession, began with the collapse of the housing market and the subprime securities market. Understanding exactly what happened, and why, has been the subject of a good deal of academic work, much of it pointing in different directions. In the years leading up to the crisis, these institutions held a wide variety of loans, including residential mortgages, auto loans, and credit card loans, which traditionally were held by the commercial banking sector.
Instead of being financed by deposits in commercial banks, the loans in the years leading up to 2007/2008 were funded by repurchase agreements, popularly called “repos,” and asset-backed commercial paper.
In 2007, the shadow banking system suffered a severe contraction. Why this happened is poorly understood, but a popular theory is that a lot of the short-term funds received by shadow banks prior to the crisis took the form of repurchase agreements, and many of these repos were backed by securitized mortgages as collateral. According to this view, the shadow banking system collapsed when money market funds and other cash lenders became concerned about the quality of the collateral that backed repos and withdrew their funding.5
Most repos were collateralized by safe government securities, not riskier securitized mortgage products. So, while the “run on repo” may have contributed to the problems of a few repo borrowers that were relying heavily on repo with riskier collateral, this was not the main cause of the crisis. The main cause lay in asset backed commercial paper, whose risks were hidden from the balance sheets of commercial banks, but when those securities went bad and could not find buyers, they migrated back to the balance sheets of the banks depleting their capital. 5
A month before Lehman Brothers collapsed, the banking system held cash reserves equal to around $50 billion, while clearing $2,996 trillion in trades per day. That means the banks were technically liable for all those trades at any given point in the day. Thus, private capital trusted the banks to clear and process their trades, pay them if anything went wrong, and pay them interest on the loans they extended to them to make it all happen. 6
Confusing? Yes. Madness? Depends on who you talk to.
If Bear and Lehman had had fatter capital cushions, they may have lasted a couple days longer before collapsing, but no more. At the end of the day, though, it really doesn’t matter how big a bank’s capital cushion is or even what it is made of. The loss of repo funding will overwhelm any bank even if it has a lot of great capital as it would be difficult to liquidate those assets fast enough. 6
What does this mean for markets and portfolios?
The answer seems to be, not much. The overnight lending rates have calmed down as a result of liquidity infusion. The New York Federal Reserve has agreed to offer up to $75 billion a day in liquidity as needed as well as three 14-day Repo operations of at least $30 billion to quell this liquidity crunch. It seems that as the FED is figuring out a more optimal cash reserve level to keep the economy running smoothly. Over the next several months, as they undertake this challenge, liquidity crunches like this are likely to keep occurring, but the FED is ready to step in again should the situation demand it. 6
Investors should be prepared for deteriorating liquidity in the funding markets into year-end, and the impact of this on the financial markets as a whole is increased volatility. This volatility will hit sharp ratios and percolate through the system with potential costs for levered strategies and risk assets in particular. As the past few days have shown, current market liquidity conditions warrant defensive positioning overall but can also present opportunities for investors who are in a position to take them. 7,8
Over the longer-term, more structural changes will likely be made. The quantitative tightening that the FED had engaged in seems to have gone too far, and at some point, the FED will have to expand its balance sheet again to put these short-term liquidity crunches to bed. This action would create significant demand for duration, layering on top of the QE that the ECB is already engaging in. Investors around the world remain concerned that there are economic risks on the horizon and the FED will need to be careful about how and when they start to rebuild their balance sheet. 4
Appendix
- https://www.reuters.com/article/us-usa-fed-repo-tools-explainer-idUSKBN1W30EJ
- https://www.cnn.com/2019/09/17/business/overnight-lending-rate-spike-ny-fed/index.html
- https://www.wsj.com/articles/fed-to-conduct-first-overnight-repo-transactions-in-several-years-11568729757
- https://blog.pimco.com/en/2019/09/repo-rate-spike-a-tail-of-low-liquidity
- https://www.gsb.stanford.edu/insights/role-repo-financial-crisis
- https://www.cnbc.com/2019/09/18/fed-ioer-fed-cuts-rate-on-bank-reserves-amid-repo-turmoil.html
- https://fortune.com/2013/05/06/how-to-solve-the-bank-capital-goldilocks-question/
- Kelley – JPM strategist Conference call. 9/18/2019