The Global Pandemic, the Repo Market and the lack of Liquidity
“Those who do not remember the past are condemned to repeat it”
-Santayana
It was bad
before the virus
The
corona virus may simply be a trigger of America’s economic strains and
imbalances which existed before the pandemic.
As
indicated by the Repo market, the economy was suffering before the corona virus. The
corona virus only made things worse.
Before the virus,
prices for equities were at an all-time high in comparison to their earnings. The
yield curve was inverting— a warning indicator of potential economic distress –
where there’s a switch to short term bonds yielding more than long term bonds –
when normally long term bonds have higher yield, since there is additional risk
for lending money at a longer duration.
The worst
part is not just how businesses and cities have to shut down. But it alerted
business and lenders of the risks of default. With record low yields of 0.3%,
speculators buying bonds anticipate the Federal Reserve to print a bunch of
money and buy into the U.S treasuries, causing the yield to drop even further
and for bond prices to go up.
Hotel chains
such as Hilton, airlines, etc. may not survive without a bailout if they didn’t
have enough cash on hand. During a catastrophe or a rainy day, don’t expect
bankers to lend. The time when investing should be done is when capital is most
scarce—when blood is on the streets, when banks don’t loan, and when investors
don’t provide capital.
As of now,
total debt the world has reached an all-time high again—USD 245-250 trillion.
That is equivalent to about USD 32,500 per person on earth. The U.S’s national debt
is about 23 trillion.
Jerome
Powell’s refusal to lower bank’s reserve standards, deficit spending (U.S.
government spending of $4.829 trillion is higher than its revenue of $3.863
trillion) and the short fall of liquidity banks were experiencing, all brewed
the perfect storm. Policymakers had planned 2019 to scale back operations in
the market for repurchase agreements, or Repo, through which dealers can borrow
cash. But as the economic threat posed by the corona virus increased, the Fed
pivoted to offering almost unlimited support in the overnight lending markets
for cash.
So, after
20-30 years of huge money printing, what do central banks have to do?
Print a lot
more. Can this printing continue infinitely without implications?
China has
also printed a huge amount of money. Germany and many countries have government
bonds in issue that has zero or negative interest rate. And yet, Germany was
heading towards a recession before the corona virus.
As an
investor, when we want to preserve the purchasing power of our money, do we buy
negative interest government bonds? No.
So, who buys
them? Speculators.
What’s not
going up, as far as prices go, is corporate debt.
Speculators
can make 30 percent profits buying and selling negative interest rate bonds.
This sounds unbelievable. Also high yield corporate debt or junk bonds.
Up until this
point, pension funds and hedge funds have been struggling to find higher
yields, so they ventured into riskier junk bonds. When the economy was good,
there was demand and it could be sold off. The moment that turns, the interest
rate on these corporate debts go up.
If
speculators realize how risky these trade are, they won't do it.
Zombie companies created by low interest rates
Companies did
buybacks funded by their junk bonds to increase their treasury stock, but didn’t
realize that a prolonged virus required contingency funds. Junk bonds were
issued, and from the funds, companies purchased their own stock instead of reinvesting
it back it to their company.
These zombie
companies with poor capital structures and convoluted balance sheets only
existed due to a low interest market. Once the tide goes out, we will see who
was swimming without their pants. Pension funds who held these corporate junk
bonds will now suffer.
A further
downgrade by Moody’s or S&P, and the pension funds will have no choice but
to sell off these bonds. Once these bonds are sold, prices go down, and interest
rates will really go up—companies will have to sell their stock to pay back
bond holders to avoid bankruptcy. Bonds will rise, and stocks will drop and
there will be a credit market crunch with lots of downgrades.
Even though
we see the mortgage rates dropping, this is the calm before the storm. Once you
see the real unemployment rates rise due to the corona virus, you’ll see a very
different story taking place. Ask yourself, why is there suddenly a rise in MBS issuance
(mortgage-backed securities)?
Printing money- how long can this continue for?
For countries
with high tax rates, who still experience budget deficits— how are governments going
to refinance their low interest rate bonds to support their expenditures? Pay a
higher interest rate. But, they can’t. If they do, interest rates go up and the
world goes into deep depression.
If they
don't, how do they pay? By printing more money. The U.S. central bank, or the Federal
Reserve, has more than $5.9 trillion of assets on its books - the equivalent of
more than a quarter of annual U.S. economic output before the crisis.
Economists
are lost and they don't know what happens next.
At the very
least, the printing of money took place under Greenspan in a big way.
Then
Bernanke.
Then Yellen
Then Jerome
Powell
In other
words, 20-30 years. The last 2 to 3 decades.
Printing of
money has two direct effects -
Asset prices go
up for stocks and real estate.
Interest rate
go down.
Why?
An increase
in the supply of money - money is devalued against assets, real estates, and
shares of businesses. Therefore it appears that asset prices went up.
Interest rate
is really just the rent that borrowers pay for use of the money—
As there was
more money printed, the supply of money went up and the rent (i.e. interest
rate) for money went down.
Low interest
rates - business firms want to borrow more.
High asset
prices - business firms now have more assets to mortgage and use as collateral
Historically,
most economic and financial market crashes were brought about by the collapse
of credit markets. Businesses suddenly cannot borrow the money they want and
have to repay their loans.
When interest
rates go up, businesses makes less profits and the economy contracts. Stock
markets go down. Or businesses need to sell assets to pay their debts. Asset
prices go down.
Corporate
borrowings are now as high as on the eve of the 2008 economic collapse known as
the Global Financial Crisis. They call it the Great Recession. Remember? That's
a banker's way of avoiding the admission of a depression.
Use of Discount Window in 2008 crisis
Traditionally,
during monetary emergencies, institutions borrow credit from the Fed’s lending
facility called the Discount Window to rescue insolvent entities that fail to
secure a counterparty.
However,
there is a problem: the Discount Window is exposed to the public. If an entity
is a public company and applies for emergency funds via a lending facility, the
institution exposes it’s insolvency to society, but, more importantly,
shareholders.
During the
financial crisis, both Bear Sterns and Lehman Brothers taught us that stock
prices can go to zero when there’s even a hint of distress. A collapse in share
prices leads to the inevitable bank run, and due to the fragility of the
global, interconnected banking system, financial contagion will spread quickly.
When Bank of America purchased Merrill Lynch in 2008, if they waited a few more
days, the panic in the markets would have given them an even cheaper discount.
But, if the
Fed’s role is to maintain confidence, then the discount window becomes
obsolete.
Instead, they
needed a way to save struggling institutions “off the books” to maintain
stability in the financial system.
The “Anonymous” Repo Market and how it works
The Fed has
achieved anonymity by intervening in the repo (repurchase agreement) market.
Banks,
finance companies, investment banks, and money market funds all participate in
short term borrowing and lending on a market called the repo (repurchase
agreement) market. It is an important mechanism for short term (overnight to 2
days) borrowings amongst banks.
The repo
market provides the cash and liquidity for financial firms to run their daily
operations. It is the grease to the gears of the economy. When the repo market
chokes and cash stops flowing, trouble can reverberate through the economy.
The repo
market is a very fast way of lending and borrowing short term. Basically the
borrower puts up US government Treasuries bond to lenders to borrow up to 40
days. Instead of entering into a complex mortgage and loan agreements, the
borrower just sells the Treasuries to lenders, and agrees to buy them back in a
few days at a time, at a higher price. The price difference is the interest
payment.
Because of
the repurchase agreement, the market is called the Repo market with USD 1-2
trillion dollars per day of transactions. The usual interest rate or the effective
federal funds rate is around 2 percent to meet their reserve requirements. The
effective federal funds rate is set by the Federal Open Market Committee, or
FOMC.
Contrary to
popular belief, the Federal Reserve’s policy prohibits smaller banks and
troubled institutions from intervening directly within the repo market. They
must deposit securities — mostly in the form of treasuries — into the reserve
accounts of primary dealers: major financial institutions such as J.P Morgan
and Deutsche Bank, who then use the collateral to trade with other Repo market
participants.
Conveniently,
repo transactions are completely anonymous, and while the Fed records how much
they inject in the repo market, what primary dealers then do with the
collateral is a complete mystery.
So when any
institution gets into trouble, the central bank/Fed transfers emergency funds to
the primary dealers, who then transfer the funds to the distressed entity: a
hidden interbank bailout. It gets more interesting when you realize foreign
banks have access to the repo market, meaning the Fed can rescue any global
financial institution in secret — hidden from the public eye.
BUT...
Liquidity in Repo Markets Tighten
On 17
September 2019, suddenly lenders were reluctant to lend.
Lenders
perceived huge financial default risks. Fear is fear. Cash got tighter; people
speculated the Fed wanted to shrink its own balance sheet.
Overnight
repo rates surged to as high as 8.5%, while the Fed’s benchmark/effective fund rate
is normally traded at 2.25%, the top end of the range that the central bank/Fed targets.
Reason 1: Tax payment date for banks and treasury
debt schedule to settle
September 16
was the cut off for U.S bank’s quarterly tax payments, so a lot of money was
sucked out of accounts and deposited into the treasury. September 16 was also
the date that 78 billion of treasury debt was scheduled to settle.
Reason 2: Regulation for additional reserves kept
by banks
Others blame
post 2008-crisis regulations for banks and lenders to have additional reserves.
This rule for reserves is called the liquidity coverage ratio (LCR), where the
FDIC (Federal Deposit Insurance Corporation) and Federal Reserve System (Board)
requires a certain amount of reserves or cash on hold at the Fed at all times
to absorb shocks from economic events. Problems complicate when credit
tightens.
Reason 3: Supply and Demand Imbalance from Previous
QE
Between 2008
and 2014, the Fed engaged in Quantitative Easing (QE) to stimulate the economy.
The Fed created reserves to buy securities, dramatically expanding its balance
sheet and the supply of reserves in the banking system. As a result, the
pre-crisis framework no longer worked, so the Fed shifted to an “ample
reserves” framework with new tools – interest on excess reserves (IOER) and
overnight reverse repos (ONRRP), both interest rates that the Fed sets itself –
to control its key short-term interest rate.
In January
2019, the Federal Open Market Committee – the Fed’s policy committee –
confirmed that it “intends to continue to implement monetary policy in a regime
in which an ample supply of reserves ensures that control over the level of the
federal funds rate and other short-term interest rates is exercised primarily
through the setting of the Federal Reserve’s administered rates, and in which
active management of the supply of reserves is not required.”
When the Fed
stopped its asset purchasing program in 2014, the supply of excess reserves in
the banking system began to shrink. When the Fed started to shrink its balance
sheet in 2017, reserves fell faster.
But the Fed
didn’t know for sure the minimum level of reserves that were “ample,” and surveys
over the past year suggested reserves wouldn’t grow scarce until they fell to
less than 1.2 trillion. The Fed apparently miscalculated, in part based on
banks’ responses to Fed surveys. It turned out banks wanted (or felt compelled)
to hold more reserves than the Fed anticipated and were unwilling to lend those
reserves in the Repo market, where there were a lot of people with Treasuries
who wanted to use them as collateral for cash. As demand exceeded supply, the Repo rate rose sharply.
The Fed Intervenes to save the day
Jerome Powell
has stated that he would rather raise the reserves and provide extra funding
from the Fed itself, rather than lower the standards for liquidity requirements
for banks.
When the Fed
first intervened in September 2019, it offered at least 75 billion in daily repos and
35 billion in long-term Repo twice per week. Subsequently, it increased the
size of its daily lending to 120 billion and lowered its long-term lending. But
the Fed has signaled that it wants to wind down the intervention: Federal
Reserve Vice Chair Richard Clarida said, “It may be appropriate to gradually
transition away from active Repo operations this year,” as the Fed increases the
amount of money in the system via purchases of Treasury bills.
On October
2019, the Fed started buying short term treasuries at 60
billion a month until June of 2020 to bring back liquidity in the Repo
market.
Pseudo “Liquidity”
So the repo
market carried on, as they now have pseudo "liquidity"—life support
from the Fed. Lenders would not have to worry if borrowers would not repurchase
or if they’re unable to— that is the way the Fed tells the story. But most
people have not thought deeply about the function of propping up treasury
prices.
While Jerome
Powell wants to improve liquidity, he doesn’t want the U.S to go further in
debt by printing more money and buying an excess amount of treasuries. But by
buying the treasury stocks from banks to keep the market going, the Fed also
brings up the treasury prices, driving yield lower temporarily.
The idea is
that through large-scale purchases of various types of bonds - mostly
Treasuries and mortgage-backed securities – helps ensure that longer-term
interest rates like those for mortgages and car loans remain low and helps keep
major purchases affordable for consumers and businesses.
What’s scary
is that there is less liquidity in U.S markets today than in the 2008-2009
financial crises. Basically, Jerome Powell is trying to fix the plumbing issue
without changing monetary policy. The Fed will continue purchasing T-Bills to
grow their balance sheet, but they don’t want to print more money.
The Fed also
blamed J.P Morgan for not lending in particular. The U.S’s largest 4 banks,
which includes: J.P Morgan, Bank of America, Wells Fargo, and Citi Group, are
so big, they can influence the entire Repo market.
By December
2019, the Fed apparently has 4 trillion USD out in into the Repo market
already. The FRA-OIS spread: the difference between 3-month LIBOR (the
interbank lending rate) and the overnight index rate (the central bank/Fed’s
risk-free rate), is widening at a rapid pace, and showing building pressure
within funding markets. Clearly, liquidity is still scarce.
When the Fed
cut rates back to near zero on March 15, 2020 it restarted these large-scale
purchases and is now doing so with an open-ended commitment.
With the
Corona Virus, the Fed stepping up quantitative easing and straight up buying
from the banks—the Repo facility was originally from twice a day to the Fed
swooping in once a day to pick up treasuries and once a week on the long term Repo to once every two weeks. The Desk had started the afternoon overnight Repo
ops on March 18.
Scale back in Treasury purchases from the Fed
The Fed is
now gradually reducing the scale of Treasury purchases, going down to 50
billion per day in the month of April from 75 billion per day at the
end of March.
On March 31,
the Fed also broadened its Repo agreements with foreign central banks, allowing
them to exchange their holdings of U.S. Treasury securities for overnight
dollar loans.
In light of
more stable repurchase agreement (Repo) market conditions, the New York Fed is
reducing the frequency of some Repo operations starting May 4, 2020. The Fed's
Open Market Trading Desk plans to return to once-a-day overnight Repo
operations from the current twice-a-day schedule by eliminating the afternoon
overnight operation.
Three-month Repo operations will be conducted to once every two weeks from once a week.
It will
continue to conduct one-month Repo operations once per week.
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