When it comes to occasional (or chronic) dollar shortages, and the plumbing of the overnight lending market, which as everyone knows suffered a spectacular heart attack early this week when the overnight repo rate soared to 10%, the New York Fed and its open markets desk, is the authority on any potential plumbing blockages. Yet it now appears that the most important regional Fed when it comes to maintaining market stability, is just as clueless as the rest of us as to why the repo market froze up. sending funding rates to never before seen highs.
In an interview with the FT, New York Fed president John Williams, who earlier this year unexpectedly fired not only the head of the NY Fed's markets desk, Simon Potter, arguably the most important trader in the world, manning the world's most important trading desk but also the second most important person at the NY Fed's "Plunge Protection Team", the head of the Financial Services Group, Richard Dzina, said that the New York Fed is examining "why banks with excess cash failed to lend to the overnight money market, following a week that revealed cracks in the US’s financial plumbing."
Specifically, Williams questioned the hesitancy of the large, liquid banks, saying "the thing we need to be focused on today is not so much the level of reserves [held at the Fed]. It’s how does the market function."
What is troubling about that statement is that it is precisely the level of reserves that the New York Fed should be focusing on - after all, that would justify the repo deep freeze as it has now been abundantly clear that the US financial system will need about $400BN more in reserves, but not how the market functions: if anything, that's the one thing the NY Fed should know by now; yet the fact that the career economist Williams admits that the Fed is clueless about the market plumbing, is extremely concerning.
As noted earlier today, following several days of oversubscribed overnight repo operations to ease liquidity pressure in the market, on Friday the Fed announced it would also offer up to $90bn in two-week long loans to further reduce funding pressures during the notorious quarter-end period when liquidity tends to collapse.
Yet while this action will likely further ease the stress in the funding market, the fingerpointing has begun, with market participants claiming that the week’s volatility arose from a shortage of cash in the financial system, which in turn was the result of the unwinding of the Fed's post-financial crisis intervention. In response, Fed officials have said it's not their fault, and instead have focused on the role played by banks, or rather the role banks with excess liquidity did not play but stepping into fund their liquidity-challenged peers.
Specifically, Williams and Lorie Logan, senior vice-president in the markets group at the New York Fed, said officials were looking at why cash failed to move from banks’ accounts at the Fed into the repo market, where banks and investors borrow money in exchange for Treasuries to cover short-term funding needs.
The irony, of course, is that it is precisely the Fed's job to know why money isn't moving from point A to point B; admitting its cluelessness will not only reignite questions about why Williams fired the two most experienced traders at the Fed, but also why the Fed knows no more than the rest of us about what is going on in the interbank market.
Logan pointed to the concentration of excess cash at a small number of banks as one potential issue.
“Reserves are concentrated, the excess reserves relative to the minimum level each bank is demanding is concentrated,” she said. “And the key question is how those reserves, as the level was coming down, would get redistributed, and how smooth that redistribution process would be.”
Almost as if the Fed had no idea what the adverse consequences of its unprecedented actions would be...
To be sure, Fed officials expected some pressure in the market this week as a result of corporate tax payments and Treasury settlements, which would drain cash out of the system. As it monitored short-term lending markets, the New York Fed paid particular attention to the amount of reserves available. It did not expect the general collateral repo rate to explode from 2.5% to 10% in a matter of minutes.
Logan said the expectation had been that as repo rates rose, banks would withdraw excess cash held at the Fed and lend it into the repo market to earn the higher rate of interest. Instead, the New York Fed had to step in to provide that cash as banks remained on the sidelines as banks were terrified to enter the repo market.
Which in turn begs the question: just what are the big, well-funded banks so afraid to share some of their liquidity with their less fortunate peers? What do they know that we - and the NY Fed - don't? And tied to that, why did Margaret McConnell, the NY Fed employee tasked with foreseeing every apocalyptic outcome no matter how improbable, fail to anticipate this outcome?
One person who may have an answer is Citi's Matt King, whose latest presentation - a bear market in trust - explains everything that is wrong with the current financial system.