Fortune 25 September 2019
The repurchase, or repo, market is the grease gun that keeps financial markets lubricated, by banks and companies temporarily trading bonds for cash and then redeeming them, usually overnight. And it once worked smoothly.
Last week it hit a liquidity pothole, with a big cash shortage. The Federal Reserve swooped in with a $400 billion bailout, buying bonds from banks to inject money into the system. The term for the action is quantitative easing (QE) and it looked like a minor replay of the global financial crisis. The irony?
Banks together had more than $1.3 trillion in extra cash sitting with the Fed and earning interest—far more than the roughly $75 billion the Fed immediately pushed into the markets or even the entire $400 billion the rescue is estimated to run in its first year.
According to experts who spoke with Fortune, the bailout is a sign of something seriously wrong. There are issues with big banks, the Fed, and regulatory oversight.
Until addressed, future liquidity crises seem increasingly likely, which could slow or even shut down lending, undercutting the economy.
What happened in the Repo Market?
The Fed’s schedule calls for another $75 billion of overnight repos to be sold every business day until October 10, with certain days also offering at least $30 billion worth of 14-day repos.
The federal funds rate—which is a target rate (currently 1.75%) and an upward range (2% today) that overnight rates are intended to fall between—is supposed to govern short-term lending. Market supply and demand determine the real rates known as SOFR, or the Secured Overnight Financing Rate.
If supply of cash is short or demand is heavy, top SOFR rates go up. When supply exceeds demand, top SOFR rates drop. Last week, those top rates hit nearly 10% at one point, five times the Fed’s top target.
“[It’s] very, very strange that the repo rate skyrocketed overnight,” says Barry Mitnick, professor of business administration and public and international affairs at the University of Pittsburgh’s Katz Graduate School of Business.
That’s why the Fed started pumping billions into the system, to bring supply back into line with demand. A popular explanation for the meltdown has been an unexpected need for cash. Companies had quarterly taxes and payments due the Treasury from the latest bond auctions. But the dates were known and amounts shouldn’t have surprised anyone. “Corporate taxes can certainly be forecast,” says John McColley, who heads the liquidity strategy team at Columbia Threadneedle Investments, as could the “net of about $54 billion owed” the Treasury.
And, while extreme, this wasn’t an isolated issue. SOFR rates have come close, and even gone beyond, the upper Fed rate range “many, many times” since 2018, says Chen Zhao, chief strategist at investment research firm Alpine Micro, which supplied a report on the topic to Fortune. The jumps past the top of the Fed’s range generally come at the ends of months and quarters, “which are normal times of higher liquidity needs,” says report author Henry Wu, head of quantitative research. “It shows a lack of liquidity buffer, that’s why you’re seeing breakouts,” Wu says.
Using a combination of data from the Fed, Fortune compared the top of the SOFR range on a daily basis with the top of the Fed’s range on the same day. During almost all of 2018, the Fed’s top rate was larger than SOFR, which is what should happen. But in 2019, from Jan. 2 (trading was closed on the New Year’s Day) through Sept. 24, there were only 15 days when the Fed’s rate was higher, a complete reversal. And while the spike was strongest last week, it was part of a regularly occurring pattern. (When asked to comment, Fed staff provided some data sources as well as recorded remarks by New York Fed President John Williams to Fortune.)
A $1 trillion market springs a leak
Large corporations and banks typically hold vast quantities of highly liquid financial assets, and so they like using these markets as a means of quick and easy financing. In fact, there are more than $1 trillion worth of overnight repo transactions collateralized with US government debt occurring every day. Banks frequently go to these markets to fund the loans they issue, and to finance the trades they execute.
That’s when it’s working smoothly.
The repo market seized up last week, with median repurchase rates skyrocketing from their usual band of 2.00-2.25% to 2.46% on Monday, and 5.25% on Tuesday. Keep in mind, that’s the median rate. Some repo rates were as high as 9%, more than quadruple the Federal Reserve’s own target rate, which usually puts a cap on how high Treasury repo rates could climb.
An unlucky confluence of events, including an exceptionally large demand for cash from U.S. companies that needed to pay their corporate tax bills, sucked a lot of the available cash out of the financial markets. What happened last week was any counter-party in need of cash, and only holding collateral like Treasuries, agreed to pay the much higher going repo rates. That’s supply and demand, plain and simple, and it mirrors what happened in certain repo markets in 2007 before the housing crash and the Great Recession that followed.
So, what happened to the usual abundance of cash and liquid securities that powers the trillion-dollar repo market?
It’s been slowly evaporating, actually, for some time, since the Fed ended five years ago the policy of quantitative easing (QE), its maneuver to buy highly liquid bank securities to boost overall bank reserves. The thinking (and hope) of that controversial policy was that the increased liquidity would encourage banks to lend more and spur economic growth at the depths of the downturn.
The lack of liquidity in the repo market is only a symptom. “There isn’t any real economic catastrophe occurring,” says Tim Speiss, co-leader of the personal wealth advisors group at accounting and advisory firm EisnerAmper. “That this could be a regulatory matter makes the most sense.”
Domestic and international regulations since 2010 have been increasing the percentage of bank assets that must be liquid, which ironically exacerbates the problem. “A lot of liquid assets in the banking system are tied up by these requirements,” Zhao says, because banks must maintain the required percentages of liquid assets. If a bank uses cash for things like loans and speculative investment, the remaining liquid assets may drop below the necessary levels. Zhao estimates that lending capacity of banks has dropped as much as 25% as a result.
“When the plumbing gets clogged [in the big banks], you have these ancillary effects of not being able to finance their assets overnight,” says Kevin Heal, senior analyst and principal interest rate forecaster for Argus Research.
However, that is just one side of the coin. To increase profits, banks have focused on risky assets with higher returns. “Because banks have not shed some of their riskier assets, they don’t have the liquidity they need,” says banking regulation consultant Mayra Rodriguez Valladares. “Bankers are constantly talking about how they’re private companies and shouldn’t have such regulation. But they’re wayward teenagers and want Daddy Federal Reserve to save them.”
Banks also make 1.8% interest on money they keep on reserve with the Fed. Not just mandated on levels, but excess reserves that could use to cover liquidity shortfalls. The latter practice started with post-economic crash QE. “They had to compensate banks, which were giving up interest-bearing assets,” Zhao says. “But once you pay rates, some banks don’t have incentive to lend it out.”
The total is currently more than $1.3 trillion in excess reserves, meaning at least $19.5 billion in interest with no risk is paid to the banks every month. When repo pays 1.75% to 2.0%, banks may prefer to park all the extra and collect guaranteed interest.
There’s an additional problem, because the excess reserves are not evenly distributed. “Banks need a quantity of overnight liquidity, but they are handicapped by liquidity requirements, so they want to keep a high amount of reserves and they don’t particularly want to lend,” Wu says. Institutions with more liquidity “realize that what they have is in large demand so they raise the price, which is the interest rate.”
There is also a smaller number of banks that directly do business with the Fed than used to be the case. “It used to be 35,” Heal says. “It’s now probably down into the low twenties.” That concentrates risk and makes problems more likely.
Then there is the Fed’s attempt to wind down previous QE by selling securities back to the banks.
From the opening of 2018 to mid-2019, the Fed reduced its balance sheet by about $1 trillion, according to data from the St. Louis Fed.
In the process, banks hand to the Fed an equivalent amount of cash. “We’ve seen the Fed’s balance sheet can’t be smaller than what it is now, and probably needs to be larger,” McColley said
Finally, bank regulators like the Fed have detailed information on banks’ current financial positions and should know the percentage of liquidity and amount of excess reserves, even if not privy to banks’ internal strategies.
Without fundamental changes, the repo turmoil, and the need for continued bailouts, could happen repeatedly, putting the economy at risk. Zhao says there are three things the Fed can do to help the situation: restart QE to inject capital, change regulatory requirements, or end interest payments on excess reserves.
The QE restart has already effectively begun with the moves last week, which in recent remarks, New York Fed President John Williams called the “first non-test repo operation in many years.”
History suggests that reducing regulation on banks may not be a good idea. So, Zhao says cutting interest on excess reserves should be tried. “Get rid of it and see what happens,” he says.
More must-read stories from Fortune:
—Airbnb plans huge IPO in 2020, continuing push by tech companies to go public
—What’s the difference between a recession and a depression? Here’s what history tells us
—Why the next recession may feel very different than 2008
—Why the repo market is such a big deal—and why its $400 billion bailout is so unnerving
—Apple Card: Here are all the credit card’s 3% cash back benefits partners