Goldman- Excess Reserves Irrelevant and the FED does not need to execute Reverse Repos with Non-Primary Dealers


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Hopefully, when Goldman talks, people listen:
Clarification from author Franesco Cafagna: Views expressed in this piece are his own and are not necessarily reflect the view of Goldman Sachs

1. Do excess reserves really matter and does the FED really need to drain them?

The short answer is: I don’t think so. The total amount of reserves currently in the banking system is the sum of all Required Reserves (including a certain amount that banks hold for precautionary reasons) and Excess Reserves. The FED HAS to provide the banking system with the amount of Required Reserves it needs otherwise rates spike higher (potentially to infinity if the discount window or other forms of “marginal lending facilities” did not exist): the amount required is the result of banks’ individual credit decisions (how many loans they make) and the FED’s job is to estimate that amount and provide it to the system. But the FED does not control this number. When it comes to Excess Reserves, lots of people worry about the potential long-term inflationary impact they may have. The truth is that they don’t matter because they bear no weight in banks’ credit decisions (how many new loans they make). They simply appear on banks’ balance sheets as an Asset that gets “invested” every night in the form of a deposit that they leave at the FED and on which they currently get a 25bps remuneration. If the FED decided to drain excess reserves via Reverse Repo the impact on the system as a whole would be zero because the system as a whole is “self contained”. To understand this let’s think of the most extreme case: the FED drains all excess reserves via one giant Overnight Reverse Repo executed with all the
banks in the banking system. At a macro level all that’s happened is that each bank has changed its Excess Reserve asset (which is effectively an O/N asset) into and O/N Reverse Repo and the two are virtually identical. Another way to think of this is that Excess Reserves are ALREADY being drained every night because banks leave them on their account at the FED every night. The only thing that will change is the liquidity profile of banks IF the FED decided to execute Reverse Repos longer than 1 day: in that case a 1-day assets (excess reserve) would be transformed into a longer asset (Reverse Repo longer than 1 day). Whilst this may affect individual institutions, the system as a whole is unaffected because this amount “extra cash” in the system (excess reserves) is NOT being used for anything. It just sits at the FED every night. So effectively it’s being “drained” already every night. So all this talk about excess reserves and their potential inflationary impact seems misplaced: they are just irrelevant and the FED simply does not need to drain them because they are “self-drained” every night anyway.

2. Does the FED really need to execute Reverse Repos with Non-Primary dealers?

This item has gained press coverage following the Fed’s release of the last Fomc minutes in which it was clear that it debated the possibility of executing large scale reverse repo operations with non-primary dealers: the motivation behind this discussion is the perceived balance-sheet capacity constraint that the 16 Primary dealers might face (a Reverse Repo increases the assets of the broker-dealer entity facing the Fed). This statement by the Fed has created all kind of debate across the street with various dealers coming up with all kinds of estimates of the overall size that the Primary dealers can handle (with some estimates being as low as 100-150bn out of a total of over 800bn that the Fed might want to execute). Leaving aside the actual need to execute Reverse Repo in the first place (point 1 above) and assuming that the Fed will, in fact, choose to execute these operations because it has stated that they are part of the exit strategy policy, I think the alleged Primary Dealers’ balance sheet capacity constraint has been VASTLY exaggerated. It’s true that a Reverse Repo increases the assets of a broker-dealer entity, but this is an issue only for stand-alone broker-dealers (Jeffreys and alike). For Primary Dealers with big commercial banks operations (JPM, Citi, BOA) I don’t believe that this is an issue at all: since they are already sitting on big amounts of Excess Reserves and because 23A (which regulates the activity between a bank entity and its affiliates) does not impose any restriction on the amount of UST, Agencies and Agencies MBS repos that a bank can execute with an affiliate broker-dealer entity, this means that the JPMs of the world could potentially execute reverse repo operations with the Fed up to the amount of excess reserves they are already sitting on without increasing their balance sheet by 1 single cent: it would simply be a transformation of an asset (excess reserves of the bank entity) into another (reverse repo of the broker-dealer entity). So, in my view, the conclusion has to be that the Primary Dealers can in fact absorb a much bigger amount of Reverse Repo than originally thought even by the Fed itself and that realistically the only other counterparties that the Fed might engage directly for these kind of operations are the GSEs: but in this case the reason would not be balance sheet driven but would be driven by the distortion that the GSEs’ participation in the fed funds mkt creates (call me if you would like to discuss this further).

By Franesco Cafagna


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ECB 1 year term repo


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This should bring down the term structure of rates at least out to one year, especially if the program is ongoing at this fixed rate.

And, operationally, it’s a similarly simple matter to set ‘risk free’ rates out the entire curve.

So, for example, bringing down rates out to a year could steepen the entire curve, but a follow up program to do the same for longer term rates could then flatten the curve.

And ‘turning the program on and off’ can add volatility as well.

Asikainen : Long Term Repo Operation (LTRO)

Next Thursday, the ECB will offer the market a funding tender which will let members of the system borrow at 1.0% for up to a year. Yes – term funding, secured by the ECB, at bargain-low rates for a year. You can pledge anything that is BBB or higher, and the ECB will fill unlimited supply at 1.00%. If they get EUR100 billion pledged? Filled. If they get EUR 2 trillion pledged? Filled.


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Fed Repo Facility


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It is something they want but seems there is no viable plan yet.

It is harder than it sounds and what they do come up with if short of a government guaranteed market will have similar risks.

The ‘answer’ is the repo markets add no value to the real economy and therefore there is no public purpose behind creating a ‘better one.’

I would just let the banks continue to price risk for secured lending as they are doing and let the interest spreads (and disintermediation when borrowers and lenders find each other directly) fall where they may due to competitive pressures.

Fed plans repo markets revamp

by Henny Sender and Michael Mackenzie

June 21 (FT) — The US Federal Reserve is considering dramatic changes to the giant repurchase – or repo – markets where banks around the world raise overnight dollar loans.

The plans include creating a utility to replace the Wall Street banks that handle transactions, people familiar with the matter say.

The Fed’s deliberations are partly motivated by concerns that the structure of the US overnight repurchase market may have exacerbated the financial turmoil that accompanied the failure of Lehman Brothers in September last year.

Fed officials plan to meet next month with market participants to discuss reforms.

People familiar with the Fed’s thinking say it is looking into the creation of a mechanism to replace the clearing banks – the biggest of which are JPMorgan Chase and Bank of New York Mellon – that serve as intermediaries between borrowers and lenders.

“The Fed is raising questions about whether the system really protects the interests of all participants,” says one person familiar with the Fed’s thinking.

In the repo markets, borrowers, such as banks, pledge collateral in return for overnight loans from lenders, such as money market funds.

The clearing banks stand between the parties, providing services such as valuing the collateral and advancing cash during the hours when trades are being made and unwound.

Fed officials fear this arrangement puts the clearing banks in a difficult position in a crisis. As the value of the securities falls, clearing banks have an obligation to demand more collateral to avoid losses. But in doing so, they could destabilise a rival.

“The clearing banks fear the positions of the investment banks are so large that a default would be difficult for them to manage,” the person familiar with the Fed’s thinking said.

“[Everyone] is thinking about how to remove conflicts of interest of the clearing banks and the investment banks so that the investment banks aren’t vulnerable to a sudden restriction of credit.”

The system’s complications were evident during Lehman’s collapse. JPMorgan, one of Lehman’s biggest trading partners, acted as its clearing bank in the repo market and – along with BoNY Mellon – served as the clearing bank for the New York Federal Reserve’s credit facility for securities ­companies.

Lawyers for the Lehman estate and for creditors have raised questions about whether JPMorgan acted too aggressively in seizing and marking down Lehman’s collateral.

Hedge funds have bought Lehman debt on the theory that the estate can claw back some of that collateral in court.

Citing confidentiality concerns, JPMorgan declined to comment.

The Fed hopes to have a new repo system in place by October, when its credit facility for securities companies is to close.


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AVM Repo Commentary


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Good report, thanks, and another example of blood flowing around the clot.

Scorecard:

  • Financial sector in a shambles
  • A2 GDP now forecast at 3% or more helped by tax cuts/rebates
  • So as the financial sector worsens the government can cut taxes to sustain output and growth.

    Seems like a good trade off to me – cut taxes and shut down the financial sector!


    Report from Jeff:

    Not only has this become a major focus of the Repo market and gotten some regulator attention, but it has gotten a lot of interest and questions from AVM Repo Commentary readers. I am speaking about Direct Repo or non-Traditional Repo. So, I will explain the concept further. This is the expansion of the Repo market to improve liquidity by pairing collateral providers directly with cash providers. This enhances the liquidity typically provided by the broker/dealers (who pair collateral providers with cash providers among themselves in the interdealer broker market and BrokerTec). These broker/dealers are currently balance sheet constrained due to: reduced capital and difficulty raising capital; taking on their SIVs’ collateral ; taking on their ARS collateral; and management directive to reduce balance sheet and reserve it for assets with higher ROA than repo. The broker/dealers are actively financing their collateral with the Federal Reserve, but have little dry powder to take on collateral from typical Repo collateral providers. This has a ripple effect in the Repo market, causing not only the collateral providers to scramble for financing but also the cash providers to eventually have trouble finding enough Repo collateral offered by the broker/dealers. The first ripple is already being felt by the market and the second ripple may now be showing up. So, the Repo market is evolving to transact Direct Repo between the cash providers and the collateral providers, which helps the broker/dealers, who still want to sell collateral to clients but don’t have the room on their balance sheet to then finance that collateral. It also, logically, compresses the bid/offer spread, which has widened dramatically due to the new ROA guidelines at most broker/dealers. As an example, Agency MBS pools have a 50bp bid/offer spread 1month (as opposed to the traditional 10bp) and Investment Grade Corporates have a 70bp bid/offer spread 1month. Direct Repo could result in significant savings for both the cash provider and the collateral provider. Other terms, such as length of trade and haircut, may also be more favorable to both sides in Direct Repo. Obviously, both the cash provider and the collateral provider would have to do Credit analysis of their counterparties, but they do that already with their broker/dealers as counterparties. Also, Direct Repo can be done as Triparty Repo, reaping the benefits of that product (no fails, less administrative work, third party pricing, third party oversight, etc.) So, this Direct Repo does not replace traditional Repo through broker/dealers, but just picks up the slack in the market, reduces the balance sheet bottleneck, and helps the broker/dealers continue to do business without having to turn away Repo clients. Anyway, I don’t want to bore you any further, so if you would like more information of how AVM Solutions can provide Direct Repo and pair cash providers with collateral providers, as well as broker/dealers, give me a call or an email.
     
     

    COLLATERAL PROVIDERS CASH PROVIDERS
    Hedge Funds Money Funds
    Asset Managers Money/Investment Managers
    Credit Unions Credit Unions
    Central Banks International Banks
    Thrifts/Community Banks Municipalities
    Pension Funds Seclending Agents (Reinvestment)
    Seclending Agents Corporations
    Beneficial Owners Broker/Dealers
    Regional Dealer clients.


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Re: Fed study on TAF


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>    
>    On Tue, Jul 29, 2008 at 4:05 AM, Andrea wrote:
>    
>    In case you haven’t seen this yet: A Fed study that finds that
>    Taf has lowered Libor.
>    
>    http://www.newyorkfed.org/research/staff_reports/sr335.html
>    
>    

right, thanks, as if they needed to fund a study to figure that out!

It’s like doing a study that shows the repo rate goes down when the fed lowers its ‘stop’ on repo.

(Too bad they didn’t use this study to show they should set a rate for the TAF and let quantity float, instead of setting a quantity and having an auction.)

It’s this kind of expense that gives govt. a govt. spending negative connotation.

all the best!

warren


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Re: US Libor GC Spreads comment

(an interoffice email)

Good report, thanks!

On Jan 4, 2008 10:41 AM, Pat Doyle wrote:
>
>
>
> Pre- August 2007 GC US Treasury’s repo averaged Libor less 17 across the
> curve. In early August and again in early December the spread between GC
> and Libor hit it’s wides in excess of 150bps for 3m repo and 180bps for
> 1mos.
>
>
>
> Today’s Spreads:
>
> 1m = L -46.5
>
> 3m = L – 77
>
> 6m = L – 82
>
>
>
> This recent narrowing of the spread is primarily a result of the TAF
> program and CB intervention but may also be attributed to continuing
> writedowns of assets. There is plenty of cash in the short term markets and
> now some of this cash is going out the curve helping to narrow Libor
> spreads. The problem banks continue to have is that their balance sheet size
> and composition is adversely affecting their capital ratios. Banks and
> Dealers remain very cautious about adding risk assets to their balance
> sheets. Bids are defensive as dealers are demanding higher rents (return
> for risk) for balance sheet. Dislocations still exist, for example it may
> make no sense from a credit perspective but AAA CMBS on open repo trades at
> FF’s + 75, while IG Corp trades FF’s + 40, even NON IG Corps trade tighter
> than AAA CMBS. The more assets are either sold or otherwise liquidated off
> of the balance sheets and the more transparent the balance sheet
> compositions become, then the quicker the markets will stabilize
>
>
>
> GRAPH OF 1 MONTH LIBOR VS. 1 MONTH UST GC
>
>

Repo Mkts and TAF

(an interoffice email)

On 12/21/07, Pat Doyle
wrote:
>
>
>
> It is becoming apparent that the funding pressures for year end are ebbing.
> The ease in pressure has a lot to do with the TAF and coordinated CBK
> interventions. The Fed is getting the cash to the people who need it.
> Discount window borrowings have been slowly climbing as well approx 4.6bb
> now. The Fed statement that they will provide this TAF facility for as long
> as needed is easing concerns amongst banks and providing a reliable source
> of funding for “hard to fund” assets.

Should have done this in August!
>
>
> There is and has been a lot of cash in the markets still looking for a home.
> Balance sheets are slowly cleaning up but balance sheet premiums (repo) will
> remain stubbornly high as long as the level 3 type assets remain on
> dealer/bank balance sheets.
>
>
>
> The current spread between the 1×4 FRA vs. 1×4 OIS is 57bps..

This looks like a good play – seems unlikely LIBOR will be at a wider spread than the discount rate. Load up the truck?

1×2 FRA vs.
> 1×2 OIS is 40bps. Spot 1mos LIBOR VS 1MOS FFs is 4.86 vs. 4.25 or 61bps.
> These spreads still represent continued unwillingness to lend in the
> interbank market and also illustrate a steeper credit curve.
>
>
>
> Turn funding has not changed substantially. While funding appears to be
> stabilizing, balance sheets are still bloated and capital ratios are still
> under pressure therefore balance sheets will remain expensive in repo land.
>
>
>
> From another bank;
>
> Mortgages over the year-end turn traded at 5.25 today, which we still feel
>
> is a good buy here considering the amount of liquidity the fed has been
> dumping
>
> into the system as of late (via the TAF and standard RP operations) and the
>
> expectation that they will continue to do so on Dec 31. Treasuries also
> traded
>
> over the turn traded today at 2.50, the first treasury turn trade we’ve seen
> in
>
> quite some time.
>
>
>
>
>
> Yesterday Tsy GC O/N’s backed up from the low 3s to 3.70. The FED has been
> actively trying to increase the supply of treasuries in the repo markets.
>
>
>
> AGENCY MBS repo has been steadily improving. 1mos OIS vs 1mos AGCY MBS has
> gone from a spreads of 63bps last week to 15bps last night. And spreads to
> 1month LIBOR have widened by 33bps AGCY MBS from L-23 12/13 to L-56 12/20.
> Again LIBOR still showing the unwillingness of banks to lend to each other.
>
>
> -Pat
>
>
>
>
> Patrick D. Doyle Jr.
>
> AVM, L.P. / III Associates
>
> 777 Yamato Road
>
> Suite 300
>
> Boca Raton, Fl. 33431
>
> 561-544-4575
>
>


♥

Fed finally gets it?

The Fed was finally successful in cutting the fed funds/libor spread with a glorified 28 day repo, after failing to narrow the spread with 100 bp of rate cuts.

Narrowing the ff/libor spread ‘automatically’ lowers various libor based funding rates, probably including jumbo mtg rates, which have been a concern of the Fed as well.

Makes me wonder if they would have cut the ff rate if they had used this ‘facility’ and narrowed the ff/libor spread right away back in August?


MBS Repo Markets

Thanks Pat, good report.

Yes, the Fed knows the assets won’t go away, and all they want is to see funding spreads narrow to help insure the banks aren’t forced to sell due to funding issues and thereby distort prices beyond prudent repricing of risk.


TAF auction (20bb) results announcement will come out tomorrow Wednesday 12/19 at 10:30am. Results of the program have had limited impact on repo rates but have reduced Libor rates by 20bps.Turn levels from Bank of America

UST GC= 2.80 / 2.40

AGCY MBS = 5.15

The problem with funding balance sheets hasn’t disappeared. The TAF and The Treasuries TTL programs have simply reduced the cost of funding but have not, and cannot, make an impact on balance sheet size or composition problems. Balance sheets are bloated with ABCP/ CLO / CDO / Enhanced Cash / Structured ABS / etc….

A quick survey of 4 dealers illustrates how balance sheet pressures and the liquidity of balance sheets have affected the bid for repo collateral. Usually dealers across the maturities dealers are within 5bps of each other. Currently the dispersion of bids is very wide.

At the same time we are finding dealers with balance sheet to lend. It’s just the prices of cash vary by dealer and by term and depend on which banks have bought term liquidity and what term they bought it for.

  1w 1m 3m 6m 9m 1y
MS 4.50 4.75 4.55 4.36   4.15
Citi 4.65 5.20 5.05 4.95 4.70 4.55
CSFB 4.45 4.90 4.80 4.70 4.60  
BoA 4.80 5.10 4.65 4.40 4.30 4.20
Ave 4.60 4.99 4.76 4.60 4.53 4.30
Range 0.35 0.45 0.50 0.59 0.40 0.40

The MBS spreads to LIBOR has narrowed as well. Agcy MBS had been trading as much as L-50 for 3m and longer terms. Now we are close to L-20. This seems to be a result of the TAF and CBK liquidity programs providing cheaper funds along the curve and reflects a relative downward move in LIBOR rates as the MBS and OIS markets are essentially unchanged from a week ago.