Nobody seemed to be paying much attention to the recent Federal Reserve bailouts in the US banking system over the past two weeks. Within a very short time, the Fed pumped hundreds of billions of dollars into the repo market. Once again, US banks are no longer able to get credit from other banks via the repo market and the Fed stepped in to save the day.
If you missed this story, if you didn’t understand it, or if you thought it was an isolated glitch of little consequence, read this! The “repo incident”, as some are now calling this episode somewhat lightheartedly, is in fact a formidable signal that investors need to pay attention to.
One of the most vital pieces of the “plumbing” of the global financial system usually runs silently and smoothly in the background, so much so that it gets overlooked by most market observers. It’s the “repo market” that offers short-term funding that banks and financial counterparties regularly tap into to lend each other trillions. That piece of plumbing has recently shown some serious leaks and has smart money very concerned.
It’s all over the news. According to Fortune, “The Fed’s Repo Market Bailout Is a Sign of Deeper Problems—That Are Getting Worse Over Time”. According to CNN, “Surging Repo Market Rates May Signal Another 2008 Economic Meltdown”. According to Martin Lowy, on Seeking Alpha, “The Repo Problem Is Deeper Than The Fed Admits”. And yet, this episode still has not received the attention that it deserves.
A bit of background
The banking system is founded largely on trust. The depositors have to trust their banks to hold their money and to return that money when needed. Most depositors understand that the banks don’t actually hold all the money deposited with them. Generally, they will only hold 10% of the deposits they owe to their clients. The rest is credited out to investors and other banks. Such is the fundamental nature of the fractional reserve banking system.
Obviously, if more than 10% of the bank’s deposits need to be paid out to clients at any point in time, the bank will have a problem. However, that problem is resolved via the repo market – a market where the banks lend to other banks on short notice.
This is a very brief and high-level summary of how things should work. However, what happens if the participating banks don’t trust each other? In other words, what if they don’t believe the other bank will pay back the money it borrowed? Well, when that happens, the Fed has to step in and add liquidity to the system.
This is exactly what happened a couple of weeks ago. By September 23rd, a US$ 400 billion bailout had taken place and the Fed has been pumping in more money ever since.
Clearly, once trust is broken, it takes BIG numbers to repair the damage. Was it repaired this time? We can’t say for sure. However, what we can say with absolute certainty is that when the wonderful (Ponzi) scheme of fractional reserve banking no longer works, a chain reaction can be triggered that is hard to stop. For the moment, things appear to have calmed down, but this is a strong signal that investors cannot afford to ignore!
Our friend, Jeff Nabers, recognized the gravity and urgency of this matter immediately and produced a number of excellent videos on the topic. If you would like to better understand the situation in the repo market, we strongly urge you to watch and learn.
The videos are best watched in the sequence presented here:
Video 1: Fed Repo Bailouts Explained (7 min)
Video 2: Are These Really Bailouts? (7 min)
Video 3: Why Do The Bank Need This Repo Bailout From The Fed? (12 min)