Henry C.K. Liu

Part 1
: The zero interest rate trap

Part II: No Exit for Emergency Nationalization
The notion that nationalization is only an emergency measure that can be undone as soon as the economy recovers appears to be wishful thinking.

Discussing the Fed’s market exit strategy problem, Bernanke said in his London School of Economics Stamp Lecture: The Crisis and the Policy Response:
Exit Strategy
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed’s lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed’s balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.
In other words, the Fed’s bank nationalization measures had not helped the economy as banks had chosen not obey government intention to increase lending. These measures had very little, if any, effect on deflation which exacerbates the need of banks for recapitalization.  

Bernanke went on:

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs–those authorized under the Federal Reserve’s so-called 13(3) authority, which requires a finding that conditions in financial markets are “unusual and exigent”–will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed’s various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee’s assessment of the condition of credit markets and the prospects for the economy.
In other words, de-nationalization will prolong the recession. Since nationalization of the financial sector had been necessary to save the financial system from imploding, it was not a Keynesian move to stimulate economic recovery, all the misleading euphemism notwithstanding. What the Fed did was to keep the critically ill patient alive with extraordinary measures, even if the cost is a drawn out long-term recovery that requires hospitalization for the rest of his life. Small government cannot be restored by big government, even temporarily. Also, near zero interest rates can hardly be described as “unattractive” to borrowers.
Bernanke went on to explain:
As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds–including loans to financial institutions, currency swaps, and purchases of commercial paper–are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy–namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters. Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term, which will slow the rate at which our balance sheet can shrink. We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Importantly, the management of the Federal Reserve’s balance sheet and the conduct of monetary policy in the future will be made easier by the recent congressional action to give the Fed the authority to pay interest on bank reserves. In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors. However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage. For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability.”

The size of the Fed’s balance sheet cannot shrink unless fed funds rate target remain near zero and fed funds rate target cannot rise above near zero until Fed balance sheet shrinks. Instead of price stability, Fed actions has created a stability of near zero interest rate and expanded Fed balance sheet. Fed balance sheet cannot shrink and zero interest rate also cannot rise in the foreseeable future.  The repurchase market, where the Fed Open Market Committee conducts its trading to keep the fed funds rate on target, has been essentially halted by zero interest rates.

Rescuing One Market at a time
There are talks that some in government are thinking of rescuing one market at a time, such as the commercial paper market, by creating a new bank along the line of Hamilton’s First Bank of the United States to buy up all toxic assets, instead of “ring fencing” toxic asset one bank at a time. The objective is not to reduce the need for further write down, but to find out once and for all how deep the loss will turn out to be to stop the continuing loss of confidence. Until confidence is restored, private capital will not return to the market.
The Systemic Lesson of the Lehman Bankruptcy
Since March 2008 the Fed internally had in its possession the latest updated market information. The picture had been increasingly ominous, revealing effects a possible Lehman collapse would have on the precarious systemic interconnections and cross-exposure to risk among investment banks, hedge funds and traders in the vast market for credit-default swaps and other derivative positions. But in the end, both potential private sector white knights to rescue Lehman and the Fed’s offer of aid blinked against Treasury’s ideological stare down against any pubic funds for a rescue of Lehman. After Lehman, the market knew that the Fed and the Treasury would no longer permit another bankruptcy if they could help it, assuming they could help it without bankrupting the government and the nation. Nationalization of the finance sector then became the only realistic option.

The Lehman bankruptcy on September 15, 2008 cut off all further private financing for investment banks. Lending in the interbank deposit market dried up as money market funds shied away from providing banks with short-term loans after Lehman’s bankruptcy wiped out billions of dollars of its impaired debt. Private funds also pulled away from the commercial paper market, an important source of finance for industrial companies and non-bank financial firms.

That breakdown prompted the Fed to announce on October 7, 2008 the creation of the Commercial Paper Funding Facility (CPFF), a facility that would complement the Fed’s existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S.

issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and such financing will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. This essentially nationalized the commercial paper market.
The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility. Since the end of October, 2008, the central bank has purchased more than $313 billion in commercial paper alone. The Fed has also implemented a number of other liquidity programs designed to help banks access funds rather than rely on the private interbank market.
Most market participants expect the Fed’s liquidity programs to remain in place at least through 2009 and that it would be a challenge for the central bank to formulate a workable exit strategy from its support of the financial system. The freeze in lending was best tracked by watching a surge in floating money market rates. At the daily fixing in London, the three-month dollar London Interbank Offered Rate (LIBOR) rose to a peak of 4.82% in October 2008.

Since then the Fed’s provision of liquidity and aggressive rate cuts has been identified as having helped ease some of the strain in LIBOR but the real reason was a drop in interbank borrowing to keep demand down. On January 9, 2009, LIBOR was at 1.41%. Strong demand for recently issued bank debt that is backed by the Federal Deposit Insurance Corp has also helped ease funding strains.
However, as of January 9, 2009, LIBOR still remained elevated when compared with near zero fed funds rate. With official overnight interest rates near zero, problems remain for the repurchase (repo) market, the other important source of bank funding, and in which Fed open market actions trade to keep the fed funds rate on target. Fear of lending securities in exchange for a short-term cash loan dominated the repo market.
Zero Interest Rate Stalls the Repo Market
The collapse of investment banks in 2008 showed how short-term funding is dependent on two factors. One is the federal funds rate, the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. The other is the government’s participation in the repurchase or “repo” market.
Data reported by 19 primary dealers5 and around 1,000 bank holding companies suggest that by mid-2008 the gross market capitalization of the US repo market exceeded $10 trillion (including double-counting of repos and reverse repos), corresponding to around 70% of US GDP.
Over the past decade, many banks also have become dependent on the repo market, whereby they lend out assets such as Treasuries, top-rated mortgages securities and other top-rated bonds in return for short-term cash. The freeze in repo financing helped bring down Bear Stearns as investors lost confidence over lending cash collateralized by Bear Stearns securities. Lehman’s bankruptcy left investors questioning the creditworthiness of all banks. Consequently, the repo market seized.
While lending for overnight continues, term repo, any agreement with a lifespan of more than one day, remained impaired by the fear factor. The breakdown in the repo market also upset the trading of interest rate swaps as dealers often hedge the derivative with government paper. The cost of financing swaps in the repo market helps influence where swaps trade relative to Treasury yields.
Heightened volatility in daily LIBOR settings made it extremely difficult to trade swaps, which involves exchanging two cash flows. One flow is a fixed rate that is priced off Treasury yields, while the floating rate references three-month LIBOR. The problems in the repo market peaked in October 2008 when failed trades rose to a record $5 trillion. A repo “fail” occurs when a security that was previously borrowed is not returned on time. (Please see my April 2, 2008 AToL article: THE SHAPE OF US POPULISM, Part 4: A panic-stricken Federal Reserve)
Given the entrenched links between dealers and investors, once a security fails, it can ripple along a long chain and shut down the repo market, which was what happened in the aftermath of the Lehman bankruptcy on September 15, 2008.
Although repo fails have since been cleaned up, the repo market faces renewed problems as the Fed’s infusion of liquidity has lowered the effective fed funds rate to nearly zero per cent. This interest rate environment negates the profit from lending out a Treasury security in exchange for a short-term cash loan.
The repo market will implement in May 2009 new rules proposed by the Treasury Market Practices Group (TMPG) which comprises senior members of security dealers, banks and investment firms who are involved in the repo market and endorsed by the Fed. The primary goal is to alleviate repo fails by introducing a penalty rate for dealing with failed securities. That will enable a security to trade at a negative level capped at 3% below current fed funds rate targets

With official rates now in a band between zero and 0.25 per cent, the cost of failing to deliver a borrowed Treasury is minimal and in such a climate, the amount of failed trades usually rises.

The TMPG said in its release: “Since November, short-term interest rates have declined to unprecedented levels, increasing the urgency to implement new practices to enhance liquidity and improve functioning of the US Treasury market.”

The use of repo is a crucial source of short term funding for financial firms as they can lend out their holdings of Treasuries and other securities as collateral in return for cash loans. Treasury traders and investors also value a smoothly functioning repo market as it allows them to sell bonds short by borrowing them from others.

Under the new rules, a charge for failing to return a borrow security on time is computed as being 3% minus the lower end of the current Fed funds rate band, which is zero per cent. Once the penalty rate is enacted at the start of May, the TMPG says the first monthly submission of claims by repo participants is expected on
June 12, 2009.

As the repo market struggles to adjust to a new regime of low and negative interest rates, and investors wait for signs that money market funds have started trusting banks again, there is no certainty that the worst is past. The wild card is another unanticipated shock to the system.

In the aftermath of the September 11, 2001 terrorist attacks, by definition ‘unprecedented’ events, the Treasury moved on October 4, 2001 to hold an unscheduled auction of 10-year Treasury notes in an effort to improve conditions in the repo market. The Treasury auctioned $6 billion more of the 5% 10-year note maturing in August 2011. The Treasury still sold 10-year notes as part of its regularly scheduled quarterly refunding in late October 2001. The Treasury acted to ameliorate risk triggered by a cascade of failed trades subsequent to the attacks of September 11, 2001. The situation was exacerbated by several factors, including increased demand for Treasury securities, disrupted telecommunications, and the reluctance of repo market participants to enter into trades, particularly as the end of the third quarter 2001 passed, out of concern for the ability of the system to regain its smooth functioning. The ‘fails rate’, a measure of trades that do not settle, which typically ranges below $3 billion, had surged as high as $40 billion by Q3, 2001.
The repo rate for general collateral that prevailed before September 11, 2001 was typically close to the federal funds rate, which was cut twice by 50 basis points each after the attacks. The first cut coming on September 17, before the halted stock market first reopened, and the second occurring on October 2, at the Federal Open Market Committee’s regular meeting. For the period immediately after September 11 and until the aforementioned October 4, 10-year note reopening, the “special” rate applying to the loan of both current 5 and 10-year notes was close to zero.
The repo market indirect influences the Treasury market and, more broadly, all fixed-income valuations and new issuance. The Treasury market and by extension the repo market is critical for everything from determining mortgage rates to funding the federal budget. The panorama of recent events is a good reminder of the role liquidity plays in the portfolio management process. This is true not only within the Treasury market, but also beyond it, in the sister fixed-income markets.
The Treasury market relies on the two-way flows of market participants, both the buyers and sellers, the offer and the bid sides. The financing of forward settlements of Treasury securities is typically accomplished in the repo market. On one side of the transaction, an entity with Treasuries on hand may chose to borrow money at a specified, often below market rate (repo rate), using the specified Treasuries as collateral. This is known as a Repurchase Agreement, or repo for short. Effectively, this participant is selling the Treasuries and repurchasing them at a later date, with the forward price being calculated using the special financing rate. On the other side of the transaction, an entity seeking to borrow those Treasuries will lend money at that same rate, effectively buying the Treasuries and selling them back at a later date (reverse repurchasing them or reverse repoing them). The forward price of the transaction is calculated using the aforementioned special financing rate. Thus for one side the transaction is a borrowing, for the other a loan, accepting cash in exchange for securities, or securities in exchange for cash respectively.
A true repo transaction involves collateral movement and often requires a ‘haircut’, or additional collateral, typically 2%, to be posted for the loan. Also, the legal documentation for repurchase transactions is specific and details the rights to control of the collateral. There are also types of repo differentiated by who holds the collateral, and what rights of substitution, if any, apply. The following is a simplistic example of the economics of a repo transaction. Specifically, the analysis is actually that of a sell/buy back transaction, where the securities transactions are entered into with settlements occurring and ownership changing. This differs from a true repo where only journal entries are made as collateral is posted and returned and ownership does not change.
The repo market is affects how a broader arena of securities is traded.  In the Treasury market, the most liquid securities that trade among dealers are typically the most recently issued benchmark Treasuries, the 2, 5, 10 and to a lesser extent the 30 year notes and bonds. Dealers trade these against other Treasury securities that are mostly held in portfolios, whether for flow or positioning reasons. Dealers use their expertise in the markets to evaluate the differences among Treasuries as to coupon and maturity (quantitative characteristics) as well as perceived availability, demand and other factors (more qualitative characteristics) so they may ultimately price them relative to the benchmarks. By extension, in sister fixed-income markets to the Treasury market, such as the agency, corporate, and mortgage-Backed securities markets, Treasury securities may also be used for the same risk and inventory management purposes. Given the size of these markets (the Treasury market alone is over $3 trillion), that the amount of activity in these benchmarks is great. Other securities in addition to Treasury benchmarks are used in a similar manner, including benchmark agency and certain large corporate issues and current coupon mortgage-backed securities. Derivative instruments, such as futures on Treasury securities are also actively employed. These in aggregate create enormous liquidity but must ultimately to some extent refer back to the cash and repo market fundamentals in deriving their valuations. There is a multiplier effect stemming from the use of benchmark securities. During periods of crisis in the financial markets, particularly a crisis in the infrastructure of the Treasury market itself, there is an extreme focus of both demand for and concern about the primary, underlying securities that represent the source of the accumulated, multiplied liquidity in the system.
Whether or not a fixed-income portfolio manager engages in repo or reverse-repo transactions directly, there is a critical indirect relationship to the repo market that must be evaluated in a number of term structure, sector and security selection issues. Over the last several years, the Treasury benchmarks have been reduced from 2, 3, 4, 5, 7, 10 and 30-year securities to 2, 5, 10 and 30-year securities. Some of this reflects securities that have simply stopped being issued, or issuance has dwindled significantly, as is the case with the 30-year.  The liquidity of these issues has become more concentrated, as the size of the Treasury market overall has been reduced and there is consolidation amongst market participants. Spreads of other securities to these benchmarks have generally widened over this period, to reflect the difference in liquidity and to reflect the economics of more favorable repo rates in benchmark Treasuries than elsewhere.  The benchmark Treasuries typically have lower yields than surrounding issues on the maturity spectrum to reflect this premium. Since Treasury issuance is itself managed to promote liquidity, the benchmark model would be incorporated in the sister fixed-income markets. The benchmark effect drives key rates on the term structure. These key rates in turn, act as fundamental valuation pillars for the different fixed-income sectors, some of which have greater clarity to the term structure than others (bullet agency or corporate as opposed to variable cash flow Mortgage-Backed securities). Finally, the actions of key rates have a great deal of impact on security selection decisions, as maturity or duration decisions are the most critical determinants of fixed-income total return.
The repo market is very large and pervasive, extending both directly and indirectly to the sister fixed-income markets. The key nexus for transmission from the repo markets is in the pricing of liquidity of the benchmark issues. The multiplier effects of liquidity in the system and the displacements that occur are substantial when either systemic de-leveraging or re-leveraging activities are conducted.
Impact on State and Local Government Finance
State and local government finance departments across the US were hit with an abrupt spike in borrowing rates as the auction-rate securities (ARS) market, a $330 billion component of the municipal bond market, collapsed in February 2008. ARS are debt instruments issued by corporations or municipalities with a long-term nominal maturity for which the interest rate is regularly reset through a Dutch auction.  Ronald Gallatin at Lehman Brothers invented ARS in 1984 and Goldman Sachs introduced the first auction rate security for the tax-exempt market in 1988. Student loan auction rate securities (SLARS) make up a large percentage of the ARS market. (Please see my September 24 2008 AToL article: Developing China with sovereign creditsection on ARS fraud investigation.)    
The $2 trillion public finance market where state and local entities raise money for roads, bridges, schools hospitals, airports and even prisons stopped functioning in early 2008. Traditionally, municipal bonds were a quiet and orderly segment of the financial markets. Returns were predictably stable and the investor base was mostly individual US tax-exempt savers. The 50,000 odd issuers, though ranging from tiny local fire departments to the gigantic state of New York, were standardized through insurance, giving the market a de facto triple-A rating. Municipal bonds as a group lost 7.6% in 2008, the worst year ever for a low-yield “save” investment vehicle. Auction-rate securities, which normally had been a source of low-cost funding for many issuers, have disappeared from the market. Long-term borrowing costs even for top-rated, triple-A municipalities have risen to nearly 6%, an eight-year high, and a backlog of more than $100 billion in postponed bond sales spilled into 2009.
Big municipal bond insurers, such as MBIA and Ambac, also had written similar policies on risky sub-prime mortgage debt. When the mortgage market cracked, so did the monolines, prompting a massive re-pricing of municipal debt to the issuers’ underlying ratings. It also upset financing arrangements like auction rate securities. (Please see my June 26, 20008 AToL article: THE ROAD TO HYPERINFLATION - Fed helpless in its own crisis)
At the same time, hedge funds, a growing group of buyers of municipal debt in recent years, became net sellers, unleashing huge supply on an already bruised muni market. The final straw that broke the market’s back came with the bankruptcy of Lehman Brothers, which drained liquidity abruptly from the whole financial system.
Lured by the high relative yields, some adventurous retail investors have stepped in, but not enough to sustain normal level of issuance. The market is expected to remain under pressure in 2009. With the economy in a recession, states and local governments are facing growing budget deficits. The federal government appears to favor stimulus for state and local economies over direct aid to state and local governments, Consequently the credit derivatives market is pricing in a greater risk of default for muni debts than for high-grade corporate bonds.
Near zero short-term interest rates are sharply corroding the smooth functioning of the government repurchase (repo) market, a foundation stone for the financial system and trading Treasury debt.
While the Federal Reserve reduced its benchmark interest rate from 1% to a new range of zero to 0.25% on December 16, 2008, short-term market rates have been trading at close to zero per cent in recent weeks. Driven by a flight to safety by investors and expectations of rate cuts, such conditions are creating problems in the repo market, where investors borrow Treasuries in return for short-term cash loans.
Repo contracts allow traders to sell Treasuries without owning them in the first place, while owners of government debt can fund their portfolios by lending Treasuries.

A zero short-term rate reduces the financial incentive to lending securities. The reduction in liquidity in the $5.8 trillion Treasury market is coming at a time when financial market conditions have become strained. The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year to fund expected fiscal deficits. President-elect Barack Obama is warning the US deficit will top $1 trillion in 2009.

The point is being reached where structural damage caused by near zero interest rates outweighs any benefit from monetary policy easing through interest rate cuts. In a financial environment where the Treasury faces an additional net financing need of over $1.8 trillion, low trading volume caused by near zero short-term rates is a major problem.
Problems in the repo market will impair general trading across the entire Treasury market. A rise in “failed” trades, where a borrowed security is not returned in time, becomes a drain on balance sheets of dealers. Near zero interest rates are also hampering the ability of dealers to finance positions by matching offsetting trades. The zero interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market.
The scarcity of Treasuries for repos means that buying for repoing will also lead Treasury prices to rise and yields to plummet. Since Treasury bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the Treasure market have the potential to feed into other markets.
Surging demand for US Treasuries is causing failures to deliver or receive government debt to climb to the highest level in almost four years in the $6.3 trillion daily market for borrowing and lending. Failures, an indication of scarcity, surged to $1.795 trillion in the week ended
March 5, 2008 the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week in 2009, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to Federal Reserve Bank of New York data.

Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills down to 0.387% in January 2009, the lowest level since 1954.

The repo market is the biggest financial market today. Domestic and international repo markets have grown dramatically over the last few years due to increasing need by market participants to take and hedge short positions in the capital and derivatives markets; a growing concern over counterparty credit risk; and the favorable capital adequacy treatment given to repos by the market. Most important of all is a growing awareness among market participants of the flexibility of repos and the wide range of markets and circumstances in which they can benefit from using repos. The use of repos in financing and leveraging market positions and short-selling, as well as in enhancing returns and mitigating risk, is indispensable for full participation in today’s financial markets.

Unless the repo market is disrupted by seizure, repos can be rolled over easily and indefinitely. What changes is the repo rate, not the availability of funds. If the repo rate rises above the rate of return of the security financed by a repo, the interest rate spread will turn negative against the borrower, producing a cash-flow loss. Even if the long-term rate rises to keep the interest rate spread positive for the borrower, the market value of the security will fall as long-term rate rises, producing a capital loss. Because of the interconnectivity of repo contracts, a systemic crisis can quickly surface from a break in any of the weak links within the market. (Please see my September 29, 2005 AToL article: The Repo Time Bomb)

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations. Repos are attractive as a monetary policy instrument because they carry a low credit risk while serving as a flexible instrument for liquidity management. In addition, they can serve as an effective mechanism for signaling the stance of monetary policy.

The secondary credit market is where Fannie Mae and Freddie Mac, so-called GSEs (government sponsored enterprises, or agencies) are traded. GSEs were founded with government help decades ago to make home ownership easier by purchasing loans that commercial lenders make, then either hold them in their portfolios or bundle them with other loans into mortgage-backed securities for sale in the credit market. Mortgage-backed securities are sold to mutual funds, pension funds, Wall Street firms and other financial investors who trade them the same way they trade Treasury securities and other bonds.  Many participants in this market source their funds in the repo market.

In this mortgage market, investors, rather than banks, set mortgage rates by setting the repo rate. Whenever the economy is expanding faster than the money supply growth, investors demand higher yields from mortgage lenders. However, the Fed is a key participant in the repo market as it has unlimited funds with which to buy repo or reverse repo agreements to set the repo rate. Investors will be reluctant to buy low-yield bonds if the Fed is expected to raise short-term rates higher. Conversely, prices of high-yeild bonds will rise (therefore lowering yields) if the Fed is expected to lower short-term rates. In a rising-rate environment, usually when the economy is viewed by the Fed as overheating, securitized loans can only be sold in the credit market if yields also rise. The reverse happens when the economy slows. But since the Fed can directly affect only the repo rate directly, the long-term rate does not always follow the short-term rate because of a range of factors, such as a time-lag, market expectation of future Fed monetary policy and other macro events. This divergence from historical correlation creates profit opportunities for hedge funds.

Investors buy bonds to lock in high yields if they expect the Fed to cut short-term rates in the future to stimulate the economy. When bond investor demand is strong, mortgage lenders can offer lower mortgage rates for consumers because high bond prices lead to lower bond yields.  But lower interest rates leads to inflation which discourages bond investment. Lower interest rates also lower the exchange value of the dollar, allowing non-dollar investors to bid up dollar asset prices. Non-dollar investors are not necessarily foreigners. They are anyone with non-dollar revenue, such as US transnational companies that sell overseas or mutual funds that invest in non-dollar economies. Unlike investors, hedge funds do not buy bonds to hold, but to speculate on the effect of interest rate trends on bond prices by going long or short on bonds of different maturity, financed by repos.

As with other financial markets, repo markets are also subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateralized markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels. In general, the art of risk management has been trailing the decline of risk aversion.  Up to a point, repo markets have offsetting effects on systemic risk. They can be more resilient than uncollateralized markets to shocks that increase uncertainty about the credit standing of counterparties, limiting the transmission of shocks. However, this benefit can be neutralized by the fact that the use of collateral in repos withdraws securities from the pool of assets that would otherwise be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they can transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which adds to systemic risk.

The Repo Market now Big and Dangerous

Created to raise funds to pay for the flood of securities sold by the US government to finance growing budget deficits in the 1970's, the repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign-exchange.

At a time around 1998 when the world’s biggest government bond market was shrinking because of a temporary US fiscal surplus, the market where investors financed their long bond purchases with short-term loans continued to grow by leaps and bounds.  The $2 trillion daily repo market in 1998 became the place where bond firms and investors raise cash to buy securities, and where corporations and money market funds park trillions of electronic dollars daily to lock in risk-free attractive returns. That market has since grown to over $5 trillion a day, almost 50% of GDP.

The repo market grew exponentially as it came to be used to raise short-term money at lower rates for financing long-term investments such as bonds and equities with higher returns. The derivatives markets also require a thriving financing market, and repos are an easy way to raise low-interest funds to pay for securities needed for arbitrage plays.  It used to be that the purchase of securities could not be financed by repos, but those restrictions have long been relaxed along with finance deregulation. Repos were used first to raise money to finance only government bonds, then corporate bonds and later to finance equities. The risk of such financing plays lies in the unexpected sudden rise in short-term rates above the fixed returns of long-term assets. For equities, rising short-term rates can directly push equity prices drastically down, reflecting the effect of interest rates on corporate profits.

Hard figures on the size of the repo market in the US or Europe are not easy to come by. The Bond Market Association, a trade group representing US bond dealers, provides estimates of US market size based on surveys taken by the New York Federal Reserve Bank on daily financing transactions made by its primary dealers that do business directly with the Fed. By Fed statistics, the US repo market command average trading volume of about $5 trillion per day in 2004, up from $2 trillion in 1998, and the European one now passed 5 trillion euros in outstandings. Both have been growing at double-digit pace. That jump occurred even as the face value of US government bonds outstanding declined to $3.3 trillion from $3.5 trillion between 1999 and 1997 -- the first drop since the Treasury began selling 30-year bonds regularly in 1977. Total Federal government debt outstanding at the end of 2004 was $7.6 trillion, nearly 70% of GDP.  In its February 2, 2005 Report to the Secretary of the Treasury, the Bond Market Association Treasury Borrowing Advisory Committee notes that the stock of Treasury debt currently held by foreigners is just over 50%, and that “with higher short rates would come greater risks of chronic or intractable fails if foreign participation in repo markets was not assured.”  The St Louis Fed reports that as of September 30, 2008, Federal debt held by foreigners amounted to over $2.86 trillion, about 18% of GDP.

The runaway repo market is another indication that the Fed is increasingly operating to support a speculative money market rather than following a monetary policy ordained by the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act.  Under the Federal Reserve Act as amended by Humphrey-Hawkins, the Federal Reserve and the Fed Open Market Committee (FOMC) are charged with the job of seeking “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  Humphrey-Hawkins mandates that, in the pursuit of these goals, the Federal Reserve and the FOMC establish annual objectives for growth in money and credit, taking account of past and prospective economic developments to support full employment. The act introduces the term "full employment" as a policy goal, although the content of the bill had been watered down before passage by snake-oil economics to consider 4% unemployment as structural. Unemployment near or below the structural level is deemed structurally inconsistent due to its impact on inflation (causing wages to rise! - a big no-no for die-hard monetarists), thus only increasing unemployment down the road. Structural unemployment is now theoretically set at 6%.

Unfortunately, aside from being morally offensive, this definition of full employment is not even good economics. It distorts real deflation as nominal low inflation and widens the gap between nominal interest rate and real interest rate, allowing demand constantly to fall behind supply. Humphrey-Hawkins has been described as the last legislative gasp of Keynesianism’s doomed effort by liberal senator Hubert Humphrey to refocus on an official policy against unemployment. Alas, most of the progressive content of the law had been thoroughly vacated even before passage. Full employment has not been a national policy for the US since the New Deal. Yet few have bothered to ask what kind of economic system is it that the richest country in the world cannot afford employment for all its citizens.

The one substantive reform provision: requiring the Fed to make public its annual target range for growth in the three monetary aggregates: the three Ms, namely M1 = currency in circulation, commercial bank demand deposits, NOW (negotiable order of withdrawal) and ATS (auto transfer from savings), credit-union share drafts, mutual-savings-bank demand deposits, non-bank traveler's checks; M2 = M1 plus overnight repurchase agreements issued by commercial banks, overnight eurodollars, savings accounts, time deposits under $100,000, money market mutual shares; and M3 = M2 plus time deposits over $100,000 and term repo agreements. A fourth category, known a L, measures M3 plus all other liquid assets such as Treasury bills, savings bonds, commercial paper, bankers’ acceptances and Eurodollar holdings of US residents (non-bank).  Changes in the financial system, particularly since the deregulation of banking and financial markets in the 1980s, have contributed to controversy among economists about the precise definition of the money supply. M1, M2 and M3 now measure money and near-money while L measures long-term liquid funds.  There is no agreement on the amount of L. The controversy is further complicated by the financing of long-term instruments with short-term repos which while being a money creation venue, can be mercuric in outstanding volume.

The persistent expansion in the money supply has been accompanied by a decline in the efficiency of money to generate GDP. In 1981, two dollars in the money supply (M3 - $2 trillion) yielded three dollars of GDP ($3 trillion), a ratio of two to three. In 2005, ten dollars in the money supply (M3 – $10 trillion) yields twelve dollars of GDP ($12 trillion), a ratio of two-and-a-half to three. It now takes 25% more money to produce the same GDP than 25 years ago.  That 25% is the unproductiveness of debt that has infested the economy, not even counting the unknown quantity of virtual money that structured finance creates.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the Fed announced that it was no longer setting such targets, because it no longer considered money-supply growth as providing a useful benchmark for the conduct of monetary policy. It is a reasonable position since no one knows what the money supply and its growth rate really are. However, the Fed said that “the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions. Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Indicators, which some market analysts use to forecast economic recessions and recoveries.”  Non-useful data yield non-useful forecasts.

Money market funds, an increasingly popular place to park cash, will need to raise fees or close to new money to remain profitable as yields hover at near-zero, according to industry managers.
The funds, which manage $3.8 trillion and have seen big cash inflows, are reeling from frozen credit markets, subprime exposure and a crisis of confidence triggered by “breaking the buck”, or returning investors less than they paid in. The cost of running money market funds is greater than the fees charged. Usually, the difference is not great, and the funds are able to pick up profit on excess yield. However, the gap between costs and fees has widened, and yields have plummeted. The average yield on a Treasury retail fund was 0.34% at the end of November 2008, compared with 2.9% in December 2007. About one in 10 money funds yields nothing. The Fed appeared to be trying to force investors out of a low-risk environment.
The overview picture is discouraging. Those in whose hands we entrust to restore health to the global financial system appear to have no clear view of how to correct the mess our global financial system has evolved into except jumping from crisis to crisis to keep the overly complex structure from collapsing. So far each move to respond to a crisis has only led to another crisis. The distressing part is that there seems to be a complacent view that nationalization is the panacea for when all else fails. We should realize that nations too can go bankrupt, even nations who were once superpowers.
January 22, 2009