A Primary Dealer Cash Shortage?

Tyler Durden's picture

When one thinks of the US banking system, the one thing few consider these days is the threat of a liquidity shortage. After all how can banks have any liquidity strain at a time when the Fed has dumped some $1.7 trillion in excess reserves into the banking system? Well, on one hand as we have shown previously, the bulk of the excess reserve cash is now solidly in the hands of foreign banks who have US-based operations. On the other, it is also safe to assume that with the biggest banks now nothing more than glorified hedge funds (courtesy of ZIRP crushing Net Interest Margin and thus the traditional bank carry trade), and with hedge funds now more net long, and thus levered, than ever according to at least one Goldman metric, banks have to match said levered bullishness to stay competitive with the hedge fund industry. Which is why the news that at noon the Fed reported that Primary Dealer borrowings from its SOMA portfolio, which amounted to $22.3 billion, just happened to be the highest such amount since 2011, may be taken by some as an indicator that suddenly the 21 Primary Dealers that face the Fed for the bulk of their liquidity needs are facing an all too real cash shortage.

For those who are unfamiliar the SOMA Securities Lending Program (described in detail here) is just another shadow conduit allowing Primary Dealers to obtain Fed funds at a tiny cost, in this case paying a fee rate that dealers paid in order to borrow the specified issues. These borrowed issues are subsequently used as downstream collateral to obtain liquidity in the shadow interbank market, or to demonstrate sufficiency of eligible quality collateral for regular way margined/levered transaction. With the average weighted rate on today's lending operation a meager 0.05% it is clear that the opportunity cost to obtain quality collateral is negligible.

Why wouldn't Primary Dealer fund all their liquidity needs using SOMA loans then? Well, for one, the Fed's SOMA portfolio was never supposed to be the gargantuan monstrosity it is now, and historically until the failure of Lehman, the primary liquidity conduit was the Fed's Discount Window (since slammed shut due to the glut in excess reserves and fear of Discount Window stigma which many say is what gave Lehman away as having acute liquidity needs in the days before its filing). On the other hand, there is a $5 billion aggregate limit per dealer, which means that loans from the Fed's SOMA while not nearly sufficient to provide wholesale funding to run a bank, are usually a last ditch liquidity conduit, which indeed has been mostly used during quarter end window dressing to make bank books appear in better shape than they usually are.

But perhaps the best definition of the Fed's securities lending operation comes once again from SourceWatch which defines it as follows:

The Federal Reserve expanded the SOMA securities lending by $36 billion (an increase of $2 billion per primary dealer, of which there were 18 as of July 27, 2009). The program provides liquidity for the dealers in the event of an emergency. It allows the borrowers to avoid reserve requirements by allowing them to post Treasury securities rather than cash as collateral for loans.

In brief: Treasurys for cash with the Fed's blessing. Got it.

Those who are curious about the actual dynamics behind the SOMA loans need to be familiar with a rather shadow-banking specific concept known as "borrow-versus-pledge" which underlies every security-for-security repo transaction. To wit, from the Fed:

Dealers that have elected to participate in the program may submit bids via their Fedline terminals. The bid rate represents the lending fee rate that a participant is willing to pay in order to borrow the security. It is not a repo rate. Because the program operates on a borrow-versus-pledge basis, the bid rate may be considered equivalent to the spread between the general collateral rate and the specials rate for the borrowed security

To understand what this means in further detail we go all the way back to 2008 and Matt King's seminal work "Are the Brokers Broken?" who explains the literal magic of how thus deemed borrowings end up completely disappearing from the dealers books:


The explanation lies in the magic of the intricacies of repo accounting, and in the way that hedge funds run their books [ZH: in this case Primary Dealer banks]. Figures 6 and 7 contrast a normal repo transaction (“borrowed versus cash”), in which cash is lent against the reverse repoing in of collateral, with a “borrowed/loaned versus pledged” transaction. The latter works in exactly the same way, except that instead of cash being lent, securities are. Another way of thinking of it is as though a counterparty had collapsed together a simultaneous repo and reverse repo transaction into a single trade. One of the counterparties is said to have “loaned versus pledged”. The other is said to have “borrowed versus pledged”. The distinction between the two is supposed to be made on the basis of who is ‘driving’ the transaction, but is best described as confusing. The magic occurs in that under FASB, borrowed versus pledged transactions do not feature on balance sheet; under IFRS, neither borrowed versus pledged nor loaned versus pledged transactions are consolidated.

In other words, a Fed loan that does not appear on the Dealers' books? The plot thickens.

But leaving all the accounting technicalities to the side, what all of the above can be summarized as is that in period of marginal liquidity squeezes, the SOMA Securities Lending Program is where Dealers go to obtain stealth funding which, for one reason or another, they desperately need.

A period such as... now.

The chart below shows the total usage of the SOMA loan portfolio.

One thing that is obvious in the chart above, and as highlighted in yellow, is the frequent, periodic quarter-end spike in lending, which, as explained above, makes sense: these are the times when Dealers, who have to open their books to their accountants for the quarter end unofficial review, do everything in their power to demonstrate a pristine balance sheet.

So what happens when one normalizes for the window dressing by assuming an average balance of the days immediately before and after? This:

The chart above allows us to appreciate a more disturbing development: the surge of PD borrowings under this program at a pace that has been unseen since the summer of 2011, when the stock market plunged by some 20% following the debt ceiling fiasco and the US downgrade, and is now as high as it was when the summer of 2011 rumblings began, and is also as high as it was during the last market swoon in March of 2012 when everyone thought Europe was fixed, when in reality it was all just the ECB's €1 trillion LTRO effect, which fizzled in March leading to yet another market correction.

So, one wonders, is the recent surge in daily SOMA lending facility usage, which was at just $5 billion on January 18, and has since spiked to $22.3 billion, more indicative of the market correction we may be entering following yesterday and today's sell off, or of more systemic liquidity problems at the Primary Dealers who, just as they always do when they run out of liquidity, go to the Fed for extra cash?

We will find out in the days to come: luckily the Fed updates the daily usage of its SOMA Lending Facility daily at this page.

We urge readers to keep a close eye on it because this time, unlike the last, there is at least a way to know in advance if the financial system is once again starting to freeze up.