The big financial news of the last week was something that we had not heard or experienced since late 2008. That was the term “REPO” and “REPO Agreements.” When last experienced, the country and the world was in a financial crisis, the worst since 1929. So the concern by many was that we might be in the midst of another crisis.
Rumors have abound about the causes for enacting REPO Agreements. I myself was very concerned with what was occurring. So I have been checking in with several solid sources to find out what was happening and what caused it. Now I can write about what has happened.
Before getting into the causes, it is important to explain what REPO Agreements are. (No, the FED is not going to repossess your home.)
Under Basel 3 and Dodd Frank, banks are required to keep a cushion of money in the event of emergencies. This money is known as reserves and is usually kept in accounts with the FED as well as money in their vaults. The purpose of the reserves is to ensure that a bank has enough capital to weather “adverse events” or “runs on banks.” In other words, the reserves are to prevent a bank from failing.
It was the lack of reserves and liquidity that froze the financial markets in 2008 and took down Lehman Brothers. The lack of reserves almost took down the entire financial system when other banks began to suffer liquidity issues as well.
(NOTE: This is a VERY simplistic explanation of bank liquidity and reserves. Trying to explain the differences in Tier 1, 2 and 3 Capital would have readers slitting wrists.)
Banks struggle daily to keep track of operational cash and reserves. They must balance customer demands against the reserves mandated by regulators.
It is very common that at the end of the working day, banks will find themselves low on money when settling accounts. To relieve the problem, banks will borrower money from other banks or the Fed to meet cash requirements. The money borrowed is that which is held in the reserve accounts in the Fed. And the rate is the “federal funds rate” established by the Fed.
Banks and other institutions have other ways to get cash quickly. One of the most common ways to raise money for a short term is through REPO Agreements.
A REPO Agreement is when one party lends cash to another party in exchange for roughly the same amount of securities. The agreement may be for as little as one day, or for a few days to a couple of weeks in some cases. The cash allows the bank to settle accounts and repay back the cash as it becomes available.
Banks or investment firms who are heavy with securities but are short on cash can execute REPO Agreements at low interest rates to obtain necessary cash and liquidity. Banks or firms with lots unused cash can earn interest that would otherwise earn nothing by participating in REPO Agreements.
The typical securities given in a REPO Agreement will be US Treasury bills, but may also be Fannie/Freddie Mortgage Backed Securities or other instruments.
So what happened to invoke the Fed to engage in REPO Agreements last week?
WHAT CAUSED THE FED TO ACT LAST WEEK?
The surprise action to execute REPO Agreements has been the subject of speculation by “experts” across the country. Each has his own theory as to what happened and why. What we do know is that there was a “liquidity crunch” within some banks or financial institutions that drove the cost of borrowing money overnight through REPO Agreements up considerably.
REPO rates can increase for a number of reasons, but the most common reason is when there is a shortage of cash in the financial system. Institutions turn to the REPO’s to cover their cash needs, and the greater demand drives up the rates.
Normally, REPO rates track closely with the Fed’s federal funds rate, which was 2% to 2.25% on Monday. The chart shows that late afternoon on Monday the 16th, the REPO rates “surged”, going up to 10% by Tuesday morning, far above the federal funds rate.
For the banks to suddenly move to REPO Agreements to meet short term cash needs, it indicates that there was a likely problem with the amount of cash reserves held by the Fed. There was not enough cash reserves to meet needs, so the banks turned to the REPO transactions, driving up the rates significantly.
The Fed, recognizing the problem, turned to issuing their own REPO Agreements, essentially creating cash that they could insert into the reserve accounts of banks. This would relieve the cash crunch in the system and keep the REPO rates down.
Additionally, when the Fed lowered rates on Tuesday to between 1.75% and 2.00% target range and continued REPO transactions, this appears to have at least stabilized the situation.
WHAT CAUSED THE LIQUIDITY CRISIS?
A number of events occurred on Monday that put pressure on the cash held by banks and other institutions.
- Monday was the deadline for companies to make their quarterly federal tax payments. Typically, banks wait until the final day to make the payments, so this created greater than expected demand.
- Monday also featured the Treasury selling $78 billion in T-bills for new debt, and that drained further cash out of the system.
- The demand for cash drove institutions to seek money from REPO Agreements driving up the rate to 10%, far above the Fed’s desired rates.
- The Fed quit Quantitative Easing (QE 3) in 2014 and since 2017, and has been unwinding their balance sheet of the extra cash that they had injected in the monetary system during and after the 2008 crisis. They miscalculated and left too little of reserves in the system. (Reserves dropped from $2.8 trillion to $1.5 trillion.)
- The Primary Dealers who buy and sell Treasury’s are holding too much of T-Bills and other securities caused by government deficits and can’t get rid of them fast enough because there is not sufficient cash sitting on the sidelines.
WHERE DOES THE FED GO FROM HERE?
With a lack of cash in the system, what are the potential actions that can be taken by the Fed to eliminate the problem?
No one would argue that lack of cash and too much demand caused the liquidity crunch. Even worse, the demand is likely to continue with the government deficits being run up and the need to issue more debt instruments to fund the deficits. Additionally, there is great demand from foreign entities and institutions to hold US debt for its security.
There is no reason to believe that the government will make any attempt to reduce deficits or pay down the outstanding debt. Demand for cash will continue to rise.
There will be two actions available for the Fed to engage in that will increase reserves and add to the monetary base.
- Get ready for QE 4, Quantitative Easing to Infinity. If the Fed cannot unwind their balance sheet for fear of creating a cash crunch, nor can they reduce deficit spending, then the only way to keep enough cash in the system is through QE.
- Create a permanent TAF (Term Auction Facility)where the Fed can and will conduct REPO and other auctions on a daily basis to keep cash in the system.
That is it. There really in nothing else that can be done.
So, in the immortal words of PU………..”WE ARE SO SCREWED!”