Reverse Repo Failure Confirmation, Primary Dealers Want Exemption From Tier One Capital Requirements To Do Reverse Repos

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A few weeks ago we speculated that the Federal Reserve's attempt to conduct a reverse repo test as part of a liquidity drainage failed. In a stunning piece of news, Zero Hedge friend Jim Bianco sent us the following. Little commentary is necessary: the banks are about to unleash the massive leverage ploy all over again, this time with the pretext that they are happy to soak up liquidity, yet in the same time, their stupidity and inability to gauge risk will blow up the financial system once again when Tier One ratios for dealers are allowed to go back to 100:1. Zero Hedge will forward this information to all of our correspondents in Washington as what the Primary Dealer community is doing is extortion, pure and simple, and it is likely to be endorsed by their cronies at the Federal Reserve (which, in turn, has already received a carte blanche to do so by its purported master, Goldman Sachs).


Today, Steve Beckner wrote the following.  We include the entire story with our highlights in red (more comments below the story).

–Fed Debating Need for Reserve Draining vs. Interest on Reserves

By Steven K. Beckner

After growing somewhat frustrated with the feasibility of doing large-scale reverse repurchase agreements with non-traditional counterparties, the Federal Reserve has begun to focus more on doing these reserve-draining operations with the primary dealer community when the time comes, Market News International understands.

The Fed has been informed by dealers that they would be willing to enter into very sizable amounts of reverse repos with the Fed, if asked to do so, provided they could get some relief from Tier I capital constraints, MNI also understands.

No decision has been made about employing reverse repos and/or other tools as part of an “exit strategy” from quantitative easing. The timing and trigger is still a matter or study and debate, which continued at the Nov. 3-4 Federal Open Market Committee meeting.There is known to be disagreement as to how much it will be necessary to reduce excess reserves through reverse repos, asset sales or other means in order ultimately to tighten credit and normalize interest rates.

Some officials believe that the Fed’s payment of interest on excess reserves will suffice to accomplish the purpose, contending that if the Fed can effectively raise interest rates the amount of reserves is not that important.

Others put more emphasis on the need to shrink the balance sheet and reduce reserves and the monetary base. And there are those who believe that some mixture of the two approaches will be required, but there is no agreement on the appropriate weight that should be given to interest on reserves and reserve draining at this time.

Reverse repos, in which the Fed sells securities with an agreement to buy them back at a slightly higher price at a later date, have been used by the Fed in the past and have been under discussion for months.

For example, on April 3, Fed Chairman Ben Bernanke said the Fed “can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities.”

Unlike asset sales, reverse repos would not necessarily reduce the size of the balance sheet or extinguish reserves on a permanent basis.

But as a practical matter, the Fed could continuously roll over the reverse repos until the underlying asset matures, thereby effectively making a permanent reserve drain.
Some officials believe the Fed need not resort to large reverse repos or asset sales, arguing that its ability to pay interest on excess reserves will set a floor under the federal funds rate and also enable the Fed to disincentivize banks from lending the reserves into the economy if necessary.

For example, San Francisco Fed President Janet Yellen, an FOMC voter, said recently that “paying interest on reserves is of itself a completely adequate tool to tighten monetary conditions.” Others feel the same way.

But there is doubt among FOMC members and Fed staff whether interest on reserves will be completely adequate given the failure of that program so far to keep the funds rate from trading below target.

What’s more, even though shorter-term Fed liquidity facilities have been shrinking due to less demand, longer term asset purchases promise to continue expanding the balance sheet. This has raised concern among other Federal Reserve presidents who argue that the Fed needs to manage down the size of reserves and the monetary base.

And so the Fed has been looking closely at using other tools to drain or immobilize reserves. Reverse repos have been a particular focus of advance preparation.

On Oct. 19, the New York Fed confirmed that it “has been working internally and with market participants on operational aspects of reverse repos to ensure that this tool will be ready when and if the Federal Open Market Committee decides they should be used.”

And it said “the focus of recent work has been to expand our existing capability to conduct reverse repos with Primary Dealers to include ‘triparty’ settlement. This has involved working with the triparty clearing banks and Primary Dealers to implement the necessary changes and updates.”

“We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future,” the New York Fed said.

The New York Fed statement also raised “the possibility of expanding the set of counterparties the Desk might employ for conducting reverse repos beyond the Primary Dealers.”

After initially hoping to be able to do a sufficient quantity of reverse repos with the dealer community, the New York Fed found it necessary to cast a wider net and entered into discussions with money market funds and government sponsored enterprises as potential counterparties.

But Market News understands that the technical and legal challenges of transacting with such non-traditional counterparties has proven somewhat daunting, leading the Fed to return its focus more on the dealer community.

When the Fed sells securities to the dealers as part of a reverse repurchase agreement, it has the effect of reducing their capital to asset ratio below regulatory minimums, limiting the amount of reverse repos the dealers are able or willing to do.

But if the Fed and other bank regulators were willing to grant an exemption from Tier One capital requirements for the reverse repos, the Fed has been informed that the dealers would be willing to do much more than they originally said — perhaps up to $1 trillion.

The Fed is said to be very receptive.

Comment

This is the first confirmation that we have read that the reverse repo test was a failure.  So, what does it mean?

Back on October 21 we also said:

[T]he Federal Reserve wants everyone to believe they have the entire process under control and they are completely capable of starting the exit strategy when if/ready. A problem with reverse repos would leave the impression that the Federal Reserve has no exit strategy and give inflation hawks fodder to believe the Federal Reserve would keep liquidity in the system too long and ignite inflation.

Let us underscore our comments with stronger language.  This entire reverse repo exercise is a diversion.  It’s purpose is to make it look like Federal Reserve staffers are busy running around “managing” monetary policy and readying for the exit strategy.  This is nothing but kabuki theater.  Now the Federal Reserve is trying to continue the rouse by suspending capital requirements with the dealers.  In other words, the dealers will accept collateral from the Federal Reserve so long as capital constraints do not get in the way of their current positions.

So, just as the outrage of the dealers leveraging 40:1 to help blow up the financial system isdying down, the Fed is “receptive” to allowing the dealers to leverage 40:1 all over again.

Will this happen?  Our guess is no.  It is more of the same … an exercise to keep everyone busy so it appears they have a plan and are busy working on it.  In reality the Federal Reserve seems to have no plan to start the exit strategy anytime soon, in fact maybe not for years.