(Bloomberg Opinion) — With their best intentions in mind, central banks and governments have instituted rules to ensure that financial institutions have enough liquidity to withstand another crisis. But liquidity coverage ratios, high quality liquid assets rules, Basel 3 compliance, global systemically important bank charges, and the soon-to-be-implemented net stable funding ratios have made supplying the all-important repo market’s needs so byzantine that no one really knows what exactly is required, least of all the Federal Reserve.
The Fed understood these new rules posed an uncertainty risk, which is why they regularly surveyed and consulted primary dealers for feedback. And yet, with no real experience with these new rules, everyone was essentially guessing. Add massive issuance of U.S. Treasury securities to meet trillion-dollar budget deficits and by mid-September the all-important repo market broke, unable to handle ever-increasing demand.
The simple fix is to roll back the regulations. Treasury Secretary Steven Mnuchin proposed just this in late October. That was quickly followed by a letter from presidential candidate Elizabeth Warren, who warned him that “These rules were designed to ensure that banks have enough cash on hand to meet their obligations in the event of another market crash,” and that “Banks are reporting profits at record levels, and it would be painfully ironic if unexplained chaos in a small corner of the banking market became an excuse to further loosen rules that protect the economy from these types of risks.”
Warren was not alone. Former Fed Vice Chairman Alan Blinder and former Federal Deposit Insurance Corp. head Shelia Bair also warned that the rules should remain in place.
Instead, the Fed intervened in the repo market by doing what it does best, burying a problem with more money until it goes away. It did this by supplying repo to the primary dealers directly and reserves to the banking system via Treasury bill purchases.
Unfortunately, the Fed made a critical design error in its daily interventions. They are offering to supply repo to the dealers at prevailing market rates. In other words, they are giving the dealers every incentive to take repo from the Fed as opposed to the market. In essence, the Fed has become the lender of first resort when it should be the lender of last resort and offer repo at a penalty rate. The Fed should be willing to help a dealer in need, but it should come at a price.
So, after four months of these Fed repo operations, new problems are emerging. More specifically, the Fed might be going too far and oversupplying this market. The effective federal funds rate is signaling there are enough reserves in the banking system. This month it traded at 1.54%, breaking below the interest on excess reserves (IOER) floor of 1.55% for the first time in 14 months. This is happening as the Fed announces it will continue to plow ahead with Treasury bill purchases and supplying hundreds of billions of dollars of repo supply until April, if not later.
- Seth Klarman, who runs Baupost Group in Boston, wrote in a letter to investors that the “the rocket fuel that has propelled markets in 2019 will run out.”
- He also noted about 31% of the fund’s portfolio was in cash to end 2019.
- Stocks are coming off a blockbuster year as the S&P 500 surged nearly 29% in 2019, its best annual performance since 2013.
- But Klarman noted in the Jan. 15 letter he is worried about a possible “liquidity trap” as low rates don’t seem to jolt economic growth, especially in Europe.
“If you push it too close to zero, you have little room to go if the need arises,” J.P. Morgan’s Jacob Frenkel said.
The NY Fed on Thursday accepted all $44.15 billion in overnight bids from primary dealers in a repurchase agreement (repo) operation meant to keep the federal funds rate within the target range.
(Bloomberg) — Allison Salas was taken aback.
As she scanned the latest collateralized loan obligations to cross her desk last spring, tucked into the deal documentation were changes that let the managers of the CLOs swap one distressed loan for another without booking a loss. In other words, they could unload an asset trading at a mere 70 cents on the dollar, buy another troubled loan, and value it at 100.
In recent months, similar loopholes have become more common, according to market watchers. Managers that assemble and oversee the securities are increasingly worried that a slowing global economy could spark a selloff in risky corporate debt, they say, and have been looking to give themselves more flexibility should things go south.
But now, some of the industry’s biggest buyers are pushing back, the latest sign of tumult in a market that has ballooned over the past decade to more than $600 billion. They’re rebuffing changes, limiting new provisions and demanding the return of prior protections.
That’s because when it comes to CLOs, which package and sell leveraged loans into chunks of varying risk and return, what’s best for Salas and other holders of safer debt tranches isn’t necessarily the same as what’s good for the firms that put the CLOs together. In fact, their interests are more closely aligned with buyers of the riskier equity portions, the piece of the pie that gets paid off last if the underlying loans struggle.