JPMorgan Blows Up The Fed's "We Can 'Control' The Crash With Reverse Repo" Plan

Tyler Durden's picture

This is a big deal. On the heels of our pointing out the surge in Treasury fails (following extensive detailing of the market's massive collateral shortage at the hands of the unmerciful Fed's buying programs), various 'strategists' wrote thinly-veiled attempts to calm market concerns that the repo market (the glur that holds risk assets together) was FUBAR. Even the Fed itself sent missives opining that their cunning Reverse-Repo facility would solve the problems and everyone should go back to the important business of BTFATHing... They are wrong - all of them - as yet again the Fed shows its ignorance of how the world works (just as it did in 2007/8 with the same shadow markets). As JPMorgan warns (not some tin-foil-hat-wearing blogger with an ax to grind) "the Fed’s reverse repo facility does little to alleviate the UST scarcity induced by the Federal Reserves’ QE programs coupled with a declining government deficit." The end result, they note, is "higher susceptibility of the repo market to collateral shortages" and thus dramatically higher financial fragility - the opposite of what the Fed 'hopes' for.


Via JPMorgan,

Reverse repos do little to alleviate UST collateral shortage

This week’s FOMC minutes provided important hints about the Fed’s exit strategy. The interest on excess reserve (IOER) rate will play a “central role” during the policy normalization process while the overnight reverse repo facility (ON RRP) would play a “supporting role” by establishing a soft floor for money market interest rates. The Committee expressed concerns not only about the potential size of the reverse repo facility, which grew rapidly since testing began last September, but also about conducting monetary policy operations with non-traditional counterparties.

Our colleagues Alex Roever and Mike Feroli have written extensively about the reverse repo facility and its impact on US money and rate markets. In this note we focus on the issue of collateral shortage and try to answer a rather narrow question: Are reverse repos alleviating collateral shortage? [Spoiler Alert: NO!]

In principle, the reverse repo facility reduces UST collateral scarcity as the Fed sells a security to an eligible RRP counterparty, thus supplying UST collateral to the market, and at the same time it drains “reserves” from the financial system which are replaced with reverse repos in the liability side of the Federal Reserve’s balance sheet. It is important to emphasize that this reserve drainage does not alter the overall liquidity injected by the Fed. It merely diverts this liquidity away from banks to non-banks, including money market funds and GSEs. But in terms of collateral shortage alleviation, we see limited improvement for several reasons:

1) The reverse repo facility has been growing rapidly but at between $100bn-$200bn currently is rather small compared to the $2.6tr of excess reserves in the liability side of the Fed’s balance sheet or the $4tr of securities in the asset side, $2.4tr of which are USTs.



2) This week’s minutes, coupled with the FOMC setting a still wide 20bp spread between the IOER and ON RRP rates, suggests that the Fed has little appetite to allow the reverse repo facility to grow to very high levels eventually. The minutes specifically mentioned that “participants discussed several potential unintended consequences of using such a facility and design features that could help to mitigate these consequences” and “a number of participants expressed concern about conducting monetary policy operations with non-traditional counterparties.”


3) The USTs sold to counterparties via the reverse repo facility are in the triparty system. Tri-party repo is a transaction for which post-trade processing is outsourced by the parties to a third-party agent. This ensures transaction efficiency and better mobilization of collateral but it does not change the legal relationship between the repo parties. With the ON RRP confined to the US tri-party system, the USTs sold to ON RRP counterparties cannot become available to other counterparties that are outside the tri-party system such as hedge funds and/or small/medium sized asset managers.


4) In addition the tri-party system applies to general collateral repo transactions so potential high demand for specific USTs, i.e. “specials”, will be difficult to be satisfied. This is because the USTs sold to ON RRP counterparties can only be re-used within the tri-party system and under general collateral repo transactions.


5) Higher margin requirements as a result of recent regulations on OTC derivative markets, for example, have caused a rise in collateral demand. But securities held within the tri-party system in the US are typically not allowed to be used to satisfy margin requirements. This means that the USTs released via the Fed’s ON RRP facility will not have the same effect in alleviating increased collateral demand stemming from higher margin requirements, than if the Fed had directly sold these UST securities to open markets.


6) Eligible RRP counterparties are currently 139 covering a wide range of entities—94 of the largest 2a-7 money market funds, six governmentsponsored enterprises (Fannie Mae, Freddie Mac, and four Federal Home Loan Banks), 18 banks, and the 21 primary dealers. That is, the Fed offers Treasury securities via its reverse repo facility to a wide set of counterparties including both banks and non-banks. But all these institutions together do not account for more than a quarter of the overnight tri-party volume. In other words, the current set of counterparties captures a modest share of the tri-party market.


7) The RRPs are expected to be collateralized by Treasury securities. SOMA’s holdings of agency debentures and agency mortgage-backed securities are available for use, but are not expected to be used in this exercise. That is, reverse repos have the potential to alleviate UST collateral scarcity but not agency collateral scarcity. Admittedly substitutability within the broader government collateral universe should reduce the importance of this last argument.

In all, we believe that the Fed’s reverse repo facility does little to alleviate the UST scarcity induced by the Federal Reserves’ QE programs coupled with a declining government deficit. And the still rising trend in UST repo fails since QE3 started in Sep 2012 suggests that the issue of UST collateral shortage remains. It is true that the repo fails are focused around specific issues, particularly hot run treasuries. It is also true that at times and in various tenors the fails spike as the desire to short USTs by certain investors exceeds the floating stock of these specific issues. But what is more concerning is the rising trend in fails which can be seen in Figure 2. The picture in Figure 2 lends support to the idea that the leverage ratio regulation has permanently reduced the appetite of broker-dealers to engage in repo markets. Via its reverse repo facility, the Fed is effectively facilitating the withdrawal of broker dealers from repo markets.

Similar to what happened in the US corporate bond market, the end result is not only structurally lower repo turnover (Figure 3) but also higher susceptibility of the repo market to collateral shortages (higher frequency of spikes in repo fails as shown in Figure 2).


*  *  *

But why do I care about some archaic money-market malarkey? Simple, Without collateral to fund repo, there is no repo; without repo, there is no leveraged positioning in financial markets; without leverage and the constant hypothecation there is nothing to maintain the stock market's exuberance (as we are already seeing in JPY and bonds).

Crucially, it should be inherently obvious to everyone that the moves we see in the stock market is not about mom and pop choosing to invest in the stock market (or not) as the 'cash on the slidelines' fallacy is "completely idiotic' but about the marginal leveraged machine (or human) quickly jumping on momentum.

The spike in "fails to deliver" highlights a major growing problem in the repo markets that provide that leverage... and thus the glue that holds stock markets together.

Wondering why JPY and bond yields have diverged so notably from stocks in recent days... repo effects (it's just a matter of time before it hits stocks)...

So that explains why the Fed is so desperate to talk you into selling your bonds - most notably the short-end by demanding you listen to what Yellen said about raising rates... as that reduces the shortfall of collateral that repo needs and restocks the banks with repo-able funds.

*  *  *

Is that why a noted dove like Jim Bullard was so visibly hawkish last week? The irony of course of the Fed explaining how rates will rise faster is that it spooks stock investors who have grown used to exuberant liquidity supply and roitates them to bonds... which merely exacerbates the problem the Fed has.

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Cattender's picture

Hell motherfucking Yeah!

Bananamerican's picture

Yea, and my last EBay customer is requesting a refund because USPS never delivered the package!!!
End times I tell yaz!!

Da Yooper's picture

Can somebody esssss - plain that in english in 50 words or less?

buzzsaw99's picture

Let me sum up. Buttercup is marrying Humperdinck in little less than half an hour. So all we have to do is get in, break up the wedding, steal the princess, make our escape... after I kill Count Rugen. [/Inigo Montoya]

max2205's picture

Belgium will bailout the Fed.....

SWRichmond's picture

We must have more Treasuries!  Quick, put the taxpayers deeper in debt!

zhandax's picture

"Can somebody esssss - plain that in english in 50 words or less?"

The fed is cranking leverage down; whether they realize it or not.

buzzsaw99's picture

It sounds to me like JPM is complaining that they are having trouble piling leverage upon leverage to keep the bubble going and they are blaming the fed, The irony is that even if the fed acceded to their request it would cause many of their other positions to get blown out of the water. it seems a bit like they are all positioning themselves to play the blame game upon each other all too aware that everyone in the whole wide world hates their guts.

disabledvet's picture

"And all we got was an invasion of the Gaza Script...err...Strip."
they've not only missed this entire rally but they're best buddies have been short...and destroyed. Damn Skippy they have a problem with collateral! The Fed sure doesn't though.

An actual economic recovery wouldn't be bad though. Maybe JPM could speak to that now that they have to lend into something other than QE!

IANAE's picture

looks like 2008 short-term funding liquidity crisis all over again... going to end badly when can't roll s/t borrowings, however collateralized... 


kaiserhoff's picture

Or better yet, an example of a specific transaction where this matters, for the benefit of the non-bond Dudes, like me;)


buzzsaw99's picture

i want to borrow ten billion to place a degenerate bet with JPM on interest rates, currency exchange rates, the market, whatever. JPM would love to lend me the money to collect a fee but all my cash is tied up in radio shack options (whatever). Now JPM can swap with the fed radio shack calls for treasury notes but i can't. so how the hell is dimon going to get his bonus for hookers and blow?

kaiserhoff's picture

It's a good thing you've got your great looks to fall back on, buzz.

You'd never make it in public relations for the banksters;)

zhandax's picture

I hear public relations for the banksters gets combat pay these days...

bentaxle's picture

So how long do you reckon before the bankers have had enough? Two quarters, or is even that too long?

ugmug's picture

The Opera is over. The fat 'Yellen' fell in the orchestra pit trying to hit the high yields and everyone smells smoke but all the exits are locked.


Da Yooper's picture

OK now that makes sence ^^^^^^^^^^^^^^^^^^^^

long-shorty's picture

"Can somebody esssss - plain that in english in 50 words or less?"

Yes, Billy Ray Valentine can.

Bananamerican's picture

"They panickin',
There won't be enuff money for the GI Joe with tha Kung foo grip. That's what all the Yellin's about"

Money_for_Nothing's picture

Fed/Banks/Dealers don't trust one another. Want colateral. At 40 to 1 leverage the collateral is hard to come by. This Fed will be criticized for the primary dealer run just like the bank runs in 1930's except corporations instead of individuals.

gmak's picture

Market players are leveraging by borrowing T-bills and T-notes from the FED and providing them as collateral against loans from other lenders. The cash is being thrown into margin accounts and leveraged again in buying financial assets. This is leverage on leverage and ALWAYS ends badly when the growth rate of the assets falls below the implicit interest rate and growth of the leverage. Re-hypothecation is the leverage on the leverage on the leverage. 

Financial assets need increasing amounts of leverage against them to grow at the same rate percentage-wise. The lack of collateral out there means the FED has to provide more. BUT the mechanism used limits the ability to re-hypothecate (or so they are saying, I believe).


Long story short: leverage on leverage on leverage is becoming leverage on leverage. If it falls to just leverage, then the asset liquidation is underway. ie asset prices will fall leading to margin calls leading to de-leveraging - and the rehypothecation means that someone will not have a chair to sit in when they need their collateral back.




If I'm a financial entity and I borrow from another (say a hedge fund using a highly leveraged margin account, or one F.E. doing a swap [derivatives] with another], a risk is created. The lender has to have capital allocated to that risk and this starts to strain the balance sheet (leverage) over time. To mitigate this risk, the lender asks for collateral, usually in the form of liquid t-notes and t-bills.

The FED has been buying up T-notes and T-bills in QE. So there aren't as many out there in private hands as there used to be. For leveraged asset "investors", getting their hands on these to use as collateral is critical. They borrow them from the FED (called a reverse repo) to give as collateral to their lenders (this is a tri-party reverse repo because the borrower of the notes and bills from the FED is not keeping them, but passing them on).


Here's the rub.

The dance of increasing leverage to buy equities and other assets has been kept going by the re-hypothecation of collateral. Apparently, a tri-party arrangement limits the amount of re-hypothecation which limits leverage. If leverage grows less than the growth rate of assets + the implied interest charges then it starts to unwind.

viahj's picture

what a mess we allowed those fuckers to weave.  ignorance + apathy of the people always comes back to haunt the people.  stand by.

RaceToTheBottom's picture

The room is getting too full of balloons for others to find a place to be blown up.

G.O.O.D's picture

this site has litterally thousands of chicken little the sky is falling articles, but this really is huge. I am not one to yell "bar the door and grab a shotgun Mabel", but this looks like the main hatchway gave in. This is way FUBAR.

garypaul's picture

OK, so stocks down but bonds would go up? Am I right on that?

gmak's picture

That is the end-game, yes. As asset prices fall or stop growing, there are margin calls. assets are liquidated but at some point there are no more assets and still margin to cover. The collateral is 'seized'. The FED now wants its T-bills and T-notes back for some reason and the borrower of these has lost them as collateral. They have to buy the instruments from somewhere and no one wants to (or can) sell. Price goes up.

holdbuysell's picture

Indeed. This seems to be up there with Matt King's "Are the Brokers Broken" report from 2008 that ZH brought to the foreground in 2011. Another must read.

Time will tell.

IANAE's picture

Just read 'Are the Brokers Broken'... spot on for what was going on at the time and ominously predictive given how little has changed.

Accounting illusions aside, the key risk in short-term funding has and always will be the inability to roll it when the SHTF, triggering desperate fire sales and, ultimately, bankruptcies (or federally brokered acquisitions) for the affected firms with attendant risk of contagion.

Current situation re short term funding liquidity risk is, unfortunately, same as it ever was only moar... one could argue it will get uglier faster this time as the players (even Fed) see it coming.

fonzannoon's picture

what was he referring to that happened in the U.S corporate bond market?

ms8172's picture

I want this to hit hard and......soon!

kaiserhoff's picture

I have always traded retail, nothing like this scale, but it looks more like a panic over counter-party risk than anything else.  At zero interest, doesn't cash work better than bonds as collateral? 

Winston Churchill's picture

Cash is too fungible.

Lest we forget,2008/9 was all about collateral in the repo market.

Fake collateral.Rehypothecated upto 42 times.

Nothing to see here,move along now folks.....

malek's picture

No worries. I'm sure they can find some more made-up collateral as needed.

buzzsaw99's picture

note to JPM: the fed AIN'T SELLING SHIT for USTs. so get that whiny shit right out of your head. ps: boo frickedy hoo for your freaking derivatives-collateral "problem". You maggots got us to where we are today so suck it up big boyz.

max2205's picture

If the fed sells Ts then that takes money out of the

buzzsaw99's picture

not really. what it would do is drop bond prices which would be stock market negative which they do not want.

G.O.O.D's picture

Which starts the machines trading lower and with the repo broken it will escalate into free fall and you better get the fvk outa the basement because this shit is caving in.

Catullus's picture

Just feeling out my understanding: the excess reserves held at the fed are meaningless at this point for the repo fails. The reserves aren't held as treasuries or agency debt, but rather credits at the fed (cash).

Getting closer to gold being used as collateral again....

buzzsaw99's picture

the problem is (from JPM's viewpoint) that the liabilities on the fed balance sheet are mostly big bank deposits which are also liabilities on their sheets. those maggots want counterparty collateral, excess reserves don't do jack, they already control those. worldwide pension funds, the billionaires, and the world central banks have cornered the UST market making quality collateral unavailable for the degenerate gamblers (cough, hedge funds, etc.) which comprise JPM's clients aka muppets. the fed won't lend (reverse repo, swap for trash, whatever :roll:) to muppets, and even if they did they would damn sure want them back which means it really isn't collateral which JPM can confiscate.

kaiserhoff's picture

Thanks buzz.  That's helpful, but depressing.  As the stomach churns...

buzzsaw99's picture

the problem with using gold or corporate bonds as collateral for hyper leverage is that the price on those can fluctuate if forced to sell into illiquid markets putting JPM at risk of a losing day which they never want to have.

kaiserhoff's picture

Yes, a losing day for Jamie would be tragic, but didn't BOFA set the record?  364 of 365 profitable or some such shit?

Let's have a pitty party for them.

seek's picture

The irony being that if gold were priced appropriately, hyper leverage wouldn't be needed and the variation (as a percentage, at least) would be much smaller. (e.g. if we just unwound the 100X rehypothecation of gold, it'd be perfect collateral.)

RaceToTheBottom's picture

Yep, probably went past the point of no return with that about 40 years ago, no doubt at a recommendation of WS Banksters

AccreditedEYE's picture

All of this is BS. The banks are openly clamoring for Vol (and looking very desperate in the process) They gained the most from Fed actions over the past 5+ years and now that Fed policy is driving their business model 6 feet under, they want change and quick. Not gonna happen.. Take any opportunity that this creates on the downside Monday to short the crap out of the VIX spike and get long risk.

They are trying to play everybody again.

garypaul's picture

You say: "Fed policy is driving their business model 6 feet under" [banks]

But then you say: "get long risk"

Isn't that a contradiction?

AccreditedEYE's picture

As ZH and others have illustrated, the banks need vol in order to make profits. Asset turn over and market stress create a need to "get out at any price". You read up and see how banks make money in this kind of environment.

As the Fed crushes Vol, risk moves higher in chase for yield and return. Banks getting what the wished for and now it's not working for the anymore.

Hughing's picture

The Fed intends to starve the bubble out through repo shortage.