What's behind the ever-increasing need for emergency repos? A couple of correspondents have an eye on shadow banking.
The shadow banking system consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking.
It is generally unregulated and not subject to the same kinds of risk, liquidity, and capital restrictions as traditional banks are.
The shadow banking system played a major role in the expansion of housing credit in the run up to the 2008 financial crisis, but has grown in size and largely escaped government oversight since then.
The above from Investopedia.
Image courtesy of my friend Chris Temple.
Hey It's Not QE, Not Even Monetary
Yesterday, I commented Fed to Increase Emergency Repos to $120 Billion, But Hey, It's Not Monetary.
Let's recap before reviewing excellent comments from a couple of valued sources.
The Fed keeps increasing the size and duration of "overnight" funding. It's now up $120 billion a day, every day, extended for weeks. That is on top of new additions.
Three Fed Statements
Emergency repos were needed for "end-of-quarter funding".
Balance sheet expansion is "not QE". Rather, it's "organic growth".
This is "not monetary policy".
Three Mish Comments
Hmm. A quick check of my calendar says the quarter ended on September 30 and today is October 23.
Hmm. Historically "organic" growth was about $2 to $3 billion.
Hmm. Somehow it takes an emergency (but let's no longer call it that), $120 billion "at least" in repetitive "overnight" repos to control interest rates, but that does not constitute "monetary policy"
I made this statement: I claim these "non-emergency", "non-QE", "non-monetary policy" operations suggest we may already be at the effective lower bound for the Fed's current balance sheet holding.
Shadow Banking Suggestion by David Collum
Mish: I also think that the repo spikes suggest the shadow banking system is finally breaking. These are spasmotic movements that nobody seems to understand.— Dave Collum (@DavidBCollum) October 24, 2019
Pater Tenebrarum at the Acting Man blog pinged me with these comments on my article, emphasis mine.
While there is too much collateral and not enough reserves to fund it, we don't know anything about the distribution [or quality] of this collateral. It could well be that some market participants do not have sufficient high quality collateral and were told to bugger off when they tried to repo it in the private markets.
Such market participants would become unable to fund their leveraged positions in CLOs or whatever else they hold.
Mind, I'm not saying that's the case, but the entire shadow banking system is opaque and we usually only find out what's what when someone keels over or is forced to report a huge loss.
Axiom7: Euro banks are starving for dollar funding and if there is a hard Brexit both UK and German banks are in big trouble. I wonder if this implies that the EU will crack in negotiations knowing that a DB fail is too-big-to-bail?
Cheesie: How do you do repos with a negative interest rate?
Harry-Ireland: [sarcastically], Of course, it's not QE. How can it be, it's the greatest economy ever and there's absolutely nobody over-leveraged and the system is as healthy as can be!
Ian: Taking bad collateral to keep banks solvent is not QE.
In regards to point number four, I commented:
This is not TARP 2009. [The Fed is not swapping money for dodgy collateral] Someone or someones is caught in some sort of borrow-short lend-long scheme and the Fed is giving them reserves for nothing in return. Where's the collateral?
Pater Tenebrarum partially agrees.
Yes, this is not "TARP" - the Fed is not taking shoddy collateral, only treasury and agency bonds are accepted. The primary dealers hold a huge inventory of treasuries that needs to be funded every day in order to provide them with the cash needed for day-to-day operations - they are one of the main sources of the "collateral surplus".
This massive, daily Fed intervention business appears to be getting worse & worse. What is the Fed hiding? The longer this goes on & the bigger the interventions get, the more my confidence is shaken. I expect that's true for other investors too. https://t.co/ozqdtUwuwv— fred hickey (@htsfhickey) October 24, 2019
We are all guessing here, so I am submitting possible ideas for discussion.
I am not convinced the Fed isn't bailing out a US major bank, foreign bank, or some other financial institution by taking rehypothecated, essentially non-existent, as collateral.
Rehypothecation is the practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.
In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.
Current Primary Dealers
Amherst Pierpont Securities LLC
Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse AG, New York Branch
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman Sachs & Co. LLC
HSBC Securities (USA) Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA LLC
Morgan Stanley & Co. LLC
NatWest Markets Securities Inc.
Nomura Securities International, Inc.
RBC Capital Markets, LLC
Societe Generale, New York Branch
TD Securities (USA) LLC
UBS Securities LLC.
Wells Fargo Securities LLC.
The above Primary Dealer List from Wikipedia as of May 6, 2019.
Anyone spot any candidates?
My gosh, how many are foreign entities?
It's important to note those are not "shadow banking" institutions, while also noting that derivative messes within those banks would be considered "shadow banking".
In this case the problem is specifically that the primary dealers are holding huge inventories of treasuries and bank reserves are apparently not sufficient to both pre-fund the daily liquidity requirements of banks and leave them with enough leeway to lend reserves to repo market participants.
The Fed itself does not accept anything except treasuries and agency MBS in its repo operations, and only organizations authorized to access the federal funds market can participate by offering collateral in exchange for Fed liquidity (mainly the primary dealers, banks, money market funds,...).
Since most of the repo lending is overnight - i.e., is reversed within a 24 hour period (except for term repos) - I don't think re-hypothecated securities play a big role in this.
But private repo markets are broader and have far more participants, so possibly there is a problem elsewhere that is propagating into the slice of the market the Fed is connected with. Note though, since the Treasury is borrowing like crazy and is at the same time rebuilding its deposits with the Fed (which lowers bank reserves, ceteris paribus), there is a several-pronged push underway that is making short term funding of treasury collateral more difficult at the moment.
So I'm not sure a case can really be made that there is anything going on beyond what meets the eye - which is already bad enough if you ask me.
Preparation for End of LIBOR
What about all the LIBOR-based derivatives with the end of LIBOR coming up?
The Wall Street Journal reports U.S. Companies Advised to Prepare for Multiple Benchmark Rates in Transition from Libor
Libor is a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans and derivatives globally. A group of banks and regulators in 2017 settled on a replacement created by the Federal Reserve known as the secured overnight financing rate, or SOFR. Companies must move away from Libor by the end of 2021, when banks will no longer be required to publish rates used to calculate it.
“We don’t expect that 100% of the Libor-based positions today will migrate 100% to SOFR,” Jeff Vitali, a partner at Ernst & Young, said this week during a panel at an Association for Financial Professionals conference in Boston. “It is going to be a scenario where entities are going to have to prepare and be flexible and build flexibility into their systems and models and processes that can handle multiple pricing environments in the same jurisdiction.”
I invite readers to consider Tenebrarum's "Repro Quake - A Primer" but caution that it is complicated.
He informs me "a credit analyst at the largest bank in my neck of the woods sent me a mail to tell me this was by far the best article on the topic he has come across".
Note: That was supposed to be a private comment to me. I placed it in as an endorsement.
Tenebrarum live in Europe. Here are his conclusions.
What Else is the Fed Missing?
Contrary to similar spikes in repo rates in 2008, it was probably not fear of counterparty risk that led to the recent repo quake. What’s more, the Federal Reserve without a doubt knew that something like this was coming. We say this because even we knew it – it was not a secret. A number of analysts have warned of just such a situation for months.
It is astonishing that the Fed somehow seemed unprepared and quite surprised by the extent of the liquidity shortage. We would submit that this fact alone is a good reason for markets to be concerned. If the Fed is not even able to properly gauge such a “technical problem” in advance, what else is there it does not know?
Effective Lower Bound
Finally, Tenebrarum commented: "I agree on your effective lower bound comment, since obviously, the 'dearth' of excess reserves was pushing up all overnight rates, including the FF rate."
For discussion of why the effective lower bound of interest rates may be much higher than zero, please see In Search of the Effective Lower Bound.