Friday, July 25, 2014

The Federal Reserve's Risky Reverse Repurchase Scheme That Could Crash the Economy

In the EPJ Daily Alert, I have been warning for sometime about the bizarre Overnight Reverse Repurchase Facility created during the reign of Ben Bernanke as head of the Federal Reserve. The facility was created as a "tool" to siphon  funds from the monetary system, specifically to be used should the $2.6 trillion that is now sitting as excess reserves begin to rapidly enter the system.

The idea is that the facility would allow money market funds to drain some of the new funds entering the system and place them at the Federal Reserve via reverse repo operations with the Fed. The problem with this is that the money markets don't have anywhere near the cash on hand to do any large scale operations of this type. They would have to sell off other securities they hold or somehow suck in more funds from other parts of the economy. There are many moving parts to such an operation and no one knows the outcome of such a massive exercise.

Sheila  Bair, a former chairwoman of the Federal Deposit Insurance Corp, does an excellent job of discussing in WSJ some of the dangers of this Fed tool. In fact, she understands that under certain circumstances use of the facility in a big way could crash the economy. She writes:
[T]oo little attention is being paid to a Federal Reserve program called the Overnight Reverse Repurchase Facility, also referred to as ON RRP. This program, while well-intentioned, could be a new source of financial instability. It needs a closer look.

The Federal Reserve Bank of New York operates the reverse repurchase facility as part of the central bank's open-market operations. The Fed "sells" securities that are part of its enormous, $4.4 trillion balance sheet to a host of financial institutions, while it simultaneously agrees to "repurchase" those assets the next day while paying the institutions a slight return (currently 0.01% to 0.05%). In effect, the Fed's counterparties are giving a secured loan to the most creditworthy borrower on the planet. They get a supersafe place to put their money and a little interest as well. Not a bad deal.

The Fed began the program in September as a way to test a potential new tool for raising interest rates whenever that day arises. Obviously, no counterparty would be willing to lend funds into the market at a rate cheaper than that paid by the Fed. So by raising the overnight reverse repurchase rate, the Fed can raise the floor rate at which their counterparties are willing to lend to other, less safe, borrowers.

I applaud the Fed's desire to eventually return interest rates to historical norms, but it is far from clear that its existing tools are insufficient to do so. The Fed can always sell government securities as part of its normal open-market operations. And Congress has given it authority to pay interest on bank reserves to set a floor on the rate at which banks will lend.

Moreover, the reverse repurchase program doesn't look like a temporary experiment. Large institutional investors, notably including money-market funds and government-sponsored entities (such as Fannie Mae   and Freddie Mac ) are using it regularly. The facility hit an overnight high of $242 billion at the end of the first quarter of 2014. The Fed has raised the overnight allotment cap for individual buyers from $500 million in September to $10 billion today.

The mere existence of this facility could exacerbate liquidity runs during times of market stress. Borrowers in the short-term debt markets will have to compete with it for investment dollars and all, to varying degrees, will be viewed as higher risk than lending to the Fed. Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.

Nonfinancial companies could find themselves unable to find buyers for their commercial paper. Banks could confront a sudden outflow of deposits, particularly those which are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer.

Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender..

Finally, the reverse repurchase facility seems to be at cross-purposes with the Fed's own efforts to address systemic risks emanating from money-market funds, which were subject to disruptive runs after Lehman Brothers collapsed in September 2008. Market pressure should be causing this unstable sector of the financial system to shrink, particularly in today's near-zero interest-rate environment. But by giving money funds a de facto insurance program, the Fed has thrown them a lifeline.

Fortunately, the Fed has made no decisions about whether to make its reverse repurchase facility permanent. At least two Federal Reserve Bank presidents—New York's Bill Dudley and Boston's Eric Rosengren —have publicly acknowledged some of the risks that it poses and the need for caps on the use of the facility. In my view the Fed should lock up the reverse repurchase facility in its toolbox and throw away the key. We need less, not more, government intervention in the financial markets.


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