Monday's Reverse Repo Test A Disaster?

Tyler Durden's picture

On Monday the Federal Reserve held a major reverse repo test, as was announced by the NY Fed and by Zero Hedge. We have subsequently received several unconfirmed reports that the conducted test has been a disaster (we have calls into the Federal Reserve to confirm or deny this, we are eagerly awaiting their reply). Presumably, after conducting various repos last year, a typical transaction would be in the $1 to $5 billion range. At around the time the financial system was being pulled apart, were two separate $50 billion repo transactions on September 18, 2008, a day when as Paul Kanjorski had highlighted earlier in the year the money market system nearly collapsed as a result of Lehman and AIG's failure, and the Reserve Fund breaking the buck. Notable about Monday's reverse repo "test" was that it was quite sizable: in the $100 billion ballpark, on parallel with the biggest liquidity extraction from 2008. The outcome was the discovery that the dealer community does not have the capacity to do reverse transactions of this magnitude. As a result the Fed was forced to go directly to the money market industry, which has been speculated as a key source of excess liquidity withdrawals, another topic we discussed previously.

This sets a dangerous precedent on two levels. First, if the dealer community, recently expanded to consist of such middle-market banks as Jefferies which allegedly has over $20 billion on its balance sheet compliments of various Fed repo actions, is unable to satisfy reverse repos of this size, a big question mark appears as to what is the illiquid collateral backing the Dealer community, if it is unable to comply with a $100 billion liquidity withdrawal. Second, it indicates that reverse repos as a source of liquidity extraction by the Fed will be contained to the very precarious money market industry. All that is needed, in today's hair-trigger mindset on liquidity, is for another systemic glitch to be made apparent to all market participants, before yet another run on money markets occurs. As readers will recall, money markets were recently stripped of their implicit Federal guarantees: as such, this is the biggest potential threat to a nascent "recovery."

We will follow this topic closely, as the rumor now is that the Fed will no longer attempt dealer-based reverse repos after Monday's failure, but confine them exclusively to money markets. Whether or not the Fed is correct in gambling with the $3 trillion+ money market industry when it should be doing all it can to extract liquidity out of the very same dealer community it has so generously been rewarding for over 7 months, is very much open to debate.

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Paul S.'s picture

"The outcome was the discovery that the dealer community does not have the capacity to do reverse transactions of this magnitude."

Doesn't have the capacity or doesn't want to?

Cognitive Dissonance's picture

I think everyone understands at this point that any significant removal of liquidity from the "dealer Community" will be the straw that breaks the camels back. This is just confirmation of that understanding.

I agree with your view. I think "they" don't want to even entertain the idea of removal at this point. Everyone is wound so tight no one wants to be the first one to begin the process of removing the punch bowl.

There is no capability for a rest or to refresh. It's either continue the express elevator to God knows what point or it's a plunge to the bottom with all the stops removed.

Steak's picture

And I would very much like to be corrected if wrong, but they are also very much against bringing what was put up as collateral back on their balance sheets, correct?  So also presumably the MM funds are now getting stuffed with BB collateral that has a AAA stamp? 

All that seems self evident from ZH's post, but I'm just making sure I'm not missing a step here.

Miles Kendig's picture

And my favorites, the securitized unrealized comps from premium credit cards and sub-prime Winnebago sales.

Gordon_Gekko's picture

I think most likely the "dealer community" along with the benevolent Fed wants the MMF's to be the bag-holders for the toxic shit the Fed has to offer for these repos. No wonder they don't have the "capacity for transactions of this magnitude". Sure.

Assetman's picture

+2

Very good observations, CD.

As ironic as it sounds, the same prime dealer community has the ability to handle trillions worth of liquidity injections.  Start taking the punchbowl away, and it's a totally different issue.

One good thing about this is that the Fed actually tested the waters on the reverse repo front well ahead of time.  It's not surprising that they didn't get the result they were hoping for... and news TD brings up here is potentially very significant.

The real danger here is that the Fed cannot respond to inflationary pressures by taking out liquidity at the pace they put it in... in fact, I would argue they will need to take out the liquidity much FASTER.  They cannot do that through conventional means, so they will do reverse repos through the money markets.  You better hope your MMMF isn't the "greater fool"-- or if they do these agreements-- they get "full faith and credit" protection in a big hurry.

One gets the sense that the Fed is really going to test the outer limits of its authority when it comes time to pull liquidity back in.  Again, this is clearly NOT a problem now... but it could be a BIG problem at the drop of a hat.

Gordon_Gekko's picture

I think we can all agree that anyone keeping any money in a MMF at this point is an idiot.

Anonymous's picture

Are you referring to the inflation factor, or the securities that will be given to the funds in a reverse repo?

Also, can you (or someone else) explain how will the MMF be screwed by this reverse repo? Isn't the money going to be swapped back at the end of the repo for the securities, or are talking about a situation where redemptions force the MMF to sell some of these securities at a lower price they paid when the repo started?

Thanks.

bonddude's picture

WHERE'S MY ROSARY BEADS ?

Anonymous's picture

You don't want to know.

Oso's picture

Any thoughts on whether them attempting to unwind this retardation is what is cratering the dollar today??

EB's picture

Indeed.  If there are truly $692 billion in bank non-borrowed excess reserves (which would be held mainly by primary dealers and are the result of QE OMOs), what is the problem?  Given the correlation between bank NBER and the stock market rally, one wonders if these "excess" reserves are otherwised encumbered or tied up in leveraged loans to momo hedge funds.

http://www.zerohedge.com/article/money-markets-are-new-suspenders

http://www.federalreserve.gov/releases/h3/hist/h3hist4.htm

 

Cognitive Dissonance's picture

Everyone remember the 1989 Loma Prieta earthquake that hit San Francisco? I still remember those pictures from the Marina district of buildings tilted at crazy angles and 2 x 4's jamed against the sides of the buildings to keep them from collapsing in the aftershocks.

I think the "$692 billion in bank non-borrowed excess reserves" are the proverbial 2 x 4's holding up this economy and no one is even considering removing one stick of supporting wood from this mess. 

Miles Kendig's picture

The duct tape & 2X4 economy in one picture.

drbill's picture

Come on! Everyone knows that duct tape holds the world together. ;-)

just.a.guy's picture

if it moves and it shouldn't -- duct tape

if it doesn't move and it should -- WD-40

 

and right now the world is AWASH in WD-40.

bonddude's picture

And that funny little guy loading grocery bags of cash out of the falling house in the Marina was...the Yankee Clipper. Yup, he didn't trust banks either. I wish he told what he knew back then.

Bearish Spirits's picture

The PDs don't have billions for a reverse repo, but they can continue to drive the market up every day.

Anonymous's picture

Very bearish.

IE's picture

"... a big question mark appears as to what is the illiquid collateral backing the Dealer community"...  Really?  A big question mark?

Anonymous's picture

pumped equities and commodities?

Printfaster's picture

The problem is that the price was not right for the PDs.  The fed needed to find a greater fool.  It seems to have found them in MMs.

 

bkrolik's picture

Most likely, for now all talks about liquidity removal are nonsense; liquidity will be added and dollar will be on the course of devaluation. I do not see any substantial group among decision makers, that would be interested in the opposite. The big question, though, what would be a catalyst to break this trend. Noticeable change in current account deficite might be it...

ElvisDog's picture

I completely agree. Any talk from the Fed about being responsible and removing liquidity is just so much B.S. The game plan from late last year has been "keep the game going and hope it gets better on its own or at the very least get one more round of bonuses". If they remove liquidity the game is over, so therefore they won't remove liquidity.

Unscarred's picture

"Whether or not the Fed is correct in gambling with the $3 trillion+ money market industry when it should be doing all it can to extract liquidity out of the very same dealer community it has so generously been rewarding for over 7 months, is very much open to debate."

It is a bit hypocritical, but how many other viable options would they actually have?

I do, however, find it a pleasant surprise that the Fed is actually trying to get out in front of the curve, for once.

Miles Kendig's picture

I cannot but help to believe that the fed is not out front, but placating the vigilantes and the Chinese.  As alluded to earlier, isn't there some 700bn  in non borrowed reserves?   All show and no go.

EB's picture

This does smell of a dog and pony show.  The Fed was clearly testing its own highwater estimate, almost looking for failure at a known breaking point, that it had previously disclosed to the FT:

"The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments."

http://www.ft.com/cms/s/0/e313ceb8-a885-11de-9242-00144feabdc0.html?catid=25&SID=google

Anonymous's picture

US Dollar down, Chinese manufacturing competetiveness
up. The Europeans are the big loosers in this game.
With tremendous slack in all Economies this could go
on for quite some time and not be inflationary.

Anonymous's picture

But I thought the fed would have no problem keeping almost a $ Trillion in excess reserves under control?

time for short rates to rise, oh wait..

Anonymous's picture

FYI, your "above the fold" summary of this says "...were two separate $50 billion repo transactions on September 18, 2009". The date is corrected to 2008 in your full article but not in the teaser.

Printfaster's picture

The fed is in no win.  If they pull money out of the MMs, then the MMs will not invest in commercial paper or other forms of industrial paper or private credit.

Either way, the fed disintermediates and kills expansion.  It looks like they press forward to kill the dollar until someone rescues it from the tracks.  I guess this is a game of chicken with the other CBs.  At the end of the day international finance is dead.

Steak's picture

I'm fascinated by the angle you mentioned...less MM funds for CP, higher short term rates, right?  So that would be a nail in the coffin for the steepener trade as well.

Printfaster's picture

Worse, the fed may be holding disappearing paper by selling their short paper and holding long.  This is a massive attempt to keep the yield curve from steeping.  It may even invert if they try to push this short term paper.

Add to that

An interesting issue has come up with regard to MBS.  The Dayton Daily News reports that bank foreclosures have stopped.  No, there are more and more homes in default, the banks have just stopped processing foreclosures.

What has happened?  The banks sold all the paper to the greater fool a long time ago.  Do the banks even have any interest in processing foreclosures since the paper is now owned by the government?

Will it be politically possible for the fed to foreclose on Fannie, Freddie, Ginnie, FHA debt?  I see all the paper that the fed holds as garbage.  Or the fed has to inflate the crap out of the currency?

 

Assetman's picture

Yep.  The Fed may have no other choice than to market short term paper-- and what complicates that is the US Treasuries own need for future issuance.  Besides ongoing deficit financing, there's a lot of short dated Treasuries that will mature over the next year or two.

Banks not processing forclosures on government owned paper is the pentultimate "screw you".  One could surmise that the FHA becomes a much bigger entity and "services" what foreclosures it can-- even for Fannie, Freddie & Ginnie.  But yeah, MBS is only worth as much as the mortgages from which its derived.

Anonymous's picture

That is a very good point regarding reverse repos with the MM funds. As the MMs seem to be the "slush fund" that loans short term to all sorts of industries and businesses, any removal of funds from the MM pool with ulitmately make all the less unavailable for use as short term loans to all sorts of businesses and commerce...

I also like the idea that the banks have loaned all the monies gotten from the FED to various hedge funds who have used it to speculate/prop up the stock market. The FED cannot get back these funds without jeopordizing the stock rally, which has also served to prop up the banks share prices and thus need for capital for reserve requirements...

Talk about boxed in a corner.

The only way I see out of this, well, there be dragons.

Trust in Allah but carry a concealed weapon.

Peterpaul in Atlanta

Anonymous's picture

The word will go out to take profits
on the stock rally and stand by to
buy Treasuries.

Nick Utah's picture

I understand a normal repo agreement: Fed takes an asset in return for posting reserves with an agreement that at a future date the asset will be returned and the reserves are given back to the FED with interest.

In the reverse repo agreement: Fed give a fully owned asset in return for cash with an agreement to take back the asset at a future date and return the cash with interest.

The problem we have is the FED now full owns assets with little known value? If the original funding to the banks was done under a true repo agreement, it would have been clear that the reserves come back from the bank they were give to. The banks want no part of taking the crap back. The FED is stuck.

I trust the MM are smart enough to know that these assets are not worth par what the FED paid for them. Maybe 10 cents on the dollar???? Who really knows. Most assets are probably worthless or even liabilities.

The FED really has now way out of this mess except to deal with the MM and hit the tax payer for the difference.

It sucks to be a tax payer.. Go Turbo Tim...

Assetman's picture

That's right... and the real issue is which "asset" the Fed will market in the reverse repo.

Hey, if it's a Treasury note backing the agreement, I'm in.  Anyone know how much in Treasuries is on the B/S currently?  Don't let it go unnoticed, though, that the Fed is exchanging T-Notes for Agency debt and banks are hoarding it in reserves.

If its toxic MBS and agency debt... I demand explicit (not implicit) guarantees on both principal AND interest at PAR VALUE.  Otherwise, I'm getting out the 10-foot pole if I'm a MM fund.  I'm sure that the Fed has some sort of magical "swap agreement" conjured up so that they are actually issuing different tranches of FR Notes to the public while quietly allowing the Treasury to absorb the losses on the really toxic assets.

That's about the only way the Fed will able able to pull this off.

Anonymous's picture

A longtime lurker asks: Is it time to pull money out of Money Markets and go for....something else?

Printfaster's picture

Given yields that are in double digit basis points, gold is now the money market instrument.  Either way , you get no interest.

 

Gordon_Gekko's picture

Yes, and that "something else" is physical Gold. If you just pull cash out of your MMF, that's just half of it (albeit a very important half). The other important thing you need to do is protect against currency devaluation (as is happening RIGHT NOW) and buy PHYSICAL Gold with it, preferably in your personal possession. 

Anonymous's picture

Yes. Go for a Treasuries-only money market fund. Then after the crash, which will I think be very sudden, buy gold and silver. Take delivery of the metals.

Anonymous's picture

So did BAC get a peak at it's reverse repo 'tab'?

Need $1B? Don't have it. Sell First Republic.

Anonymous's picture

What this tells us is that the primary dealer banks KNOW they remain grossly undercapitalized despite all the Fed liquidity gifts and interest paid on LLR capital parked at Fed reserve accounts.
Their unrealized OTC derivative and OBS losses are gigantic, and what funds they can keep from being assigned to future losses (by FASB mark-to-fantasy) are being deployed in gambling in the various markets.
The barbarians are looting the treasury while Rome burns.

The only "exit strategy" the Fed has is the helicopters idling on the roof of the New York Fed building. See Ferdinand de la Rua.

Anonymous's picture

This tells me a few things.

Just keep enough $ in the bank to cover your bills.
Nothing beats holding physical gold!
Get a professionally installed juggernaut safe bolted to your homes foundation.

Its no secret (at least to me) that the large banks are hording GOLD (while they are shorting it on the open market)

People put 2 and 2 together.

Anonymous's picture

This tells me a few things.

Just keep enough $ in the bank to cover your bills.
Nothing beats holding physical gold!
Get a professionally installed juggernaut safe bolted to your homes foundation.

Its no secret (at least to me) that the large banks are hoarding GOLD (while they are shorting it on the open market)

People put 2 and 2 together.

Anonymous's picture

This tells me a few things.

Just keep enough $ in the bank to cover your bills.
Nothing beats holding physical gold!
Get a professionally installed juggernaut safe bolted to your homes foundation.

Its no secret (at least to me) that the large banks are hoarding GOLD (while they are shorting it on the open market)

People put 2 and 2 together.

Unscarred's picture

Any word if this what caused the bump in short-term Euro commercial paper yesterday?