India and China Join the U.S. In Flirting With Recession

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The situation seemed dire. The federal government had a ton of debt to sell, and many market-watchers, maybe most of them, were growing worried about how it could. It wasn’t just a matter of demand, more so the issue of financing. The repo market was sending some very negative signals, and if the repo market isn’t working properly the ability of the system to absorb Treasury issuance is in doubt.

The headline for one Financial Times article was talking about how repo was being undermined at a particularly sticky moment:

“The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close.”

If you recall last year, the GC repo rate ended 2018 with an enormous spike. There are growing concerns repo rates at the end of this year, despite hastened Federal Reserve activities, are in for something similar.

But neither of those were the subject of the article quoted above. The year was instead 2008. Back then, Treasury “experts” saw short-term money rates drop to zero and linked them to persistent liquidity problems in repo. Funny that. The article above was written on the occasion of the FOMC voting for ZIRP that fateful December.

One strategist from Bank of America had said:

“Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries. We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.”

The thinking went like this: at such low levels there would be little or no room left from which dealers could pocket their small spread. Treasury owners like the ability to “sell” (a repo is technically but not legally a repurchase agreement, meaning you sell it today and agree to buy it back tomorrow or some other specified date) into the market so as to finance that very position. Cash lenders wanted the ability to “borrow” a security they don’t and do not want to own.

For all that to happen, you have to have dealer banks intermediate in the middle – matching prospective Treasury owners with eager Treasury borrowers. Without them, collateral flow will break down as it had more than a decade ago.

But there were huge problems in repo long before ZIRP in December 2008. By the score of repo fails, the failure of one or the other counterparty to unwind the repurchase in a timely manner, the entire system (collateral) had seized up the prior October. People today still think the Panic of 2008 had something to do with Wall Street and the stock market. It wasn’t, not really, that was a mere symptom.

According to estimates provided by the Federal Reserve’s New York branch, the one which is responsible for dealing with dealers, primary dealers had reported to it nearly $800 billion (combined “to deliver” plus “to receive”) in repo fails during the week of September 3, 2008. You might remember how immediately following the end of that particular week Fannie and Freddie were forced into federal government conservatorship.

Yet, the 4-week T-bill’s equivalent yield was still a comparatively robust 1.53%.

The week of September 17, the one begun with Lehman, AIG, Wachovia, etc., repo fails would jump to $577 billion and then skyrocket to an incomprehensible $3.5 trillion for the final week of that historic month. And fails began the next one nearer $5 trillion when stocks finally melted down.

Was that because short-term rates were plummeting, all over the place, leaving dealers to sit it out unable to charge their spread? Or was it because these same financial institutions had a front row seat for what (stupidity) had really kept the collateral flow flowing up until that time?

What is a repo fail?

You give me a UST likely a T-bill as collateral for me to lend you cash overnight. The following day we are supposed to exchange them back, with you giving me a tiny bit more cash as interest for the loan. But what if I decide I don’t want the cash back because I’d rather keep the T-bill?

That’s a repo fail.

And it is one of the most puzzling aspects of systemic “liquidity.” After all, we are all taught that cash is the most liquid instrument, and therefore in times of stress and uncertainty that’s what everyone wants. Cash, not collateral.

Yet, what the 2008 episode showed was that during times of massive strain system participants prefer the collateral to cash. Therefore, during the worst liquidity panic in four generations, nothing like this seen since the Great Depression, the repo market broke down for the inelasticity of collateral, not cash.

While this was going on, Ben Bernanke would have you believe he was fighting the good fight. He said so, to Congress on September 23 just as repo fails were about to enter the trillions.

“The Federal Reserve took a number of actions to increase liquidity and stabilize markets.  Notably, to address dollar funding pressures worldwide, we announced a significant expansion of reciprocal currency arrangements with foreign central banks, including an approximate doubling of the existing swap lines with the European Central Bank and the Swiss National Bank and the authorization of new swap facilities with the Bank of Japan, the Bank of England, and the Bank of Canada.  We will continue to work closely with colleagues at other central banks to address ongoing liquidity pressures.”

There are a couple of things which truly stand out in what he testified. First, the Federal Reserve’s Chairman talked about how he was going to “increase liquidity and stabilize markets.” He and the other FOMC members kept saying those exact things over and over and over. Liquidity and stabilize.

Did they? Not even remotely. Bernanke said liquidity but there was increasingly none. Markets stabilized? Worst panic since 1929.

And it was a global panic. That’s the other aspect you should take note from just this one piece of testimony. The Chairman said “address dollar funding pressures worldwide”, using swap lines with reciprocal major foreign central banks. Excuse me?

Why didn’t anyone ask how it could be that banks in Germany, Canada, or Japan were begging their local central bankers for funding in US dollars? Preoccupied by the official story about a US housing bubble gone wrong due to greedy Wall Street bankers and their prepackaged toxic mortgage loans, neither Congress nor the public caught on to what should have been the period’s main message.  

Combining all these elements: repo collateral, global funding in dollars, ineffective central bank. That was 2008’s Global Financial Crisis in a nutshell, not subprime mortgages.

To make matters worse, to add insult to grave global economic injury, the US central bank had classified this period as one having “abundant reserves.” I’m not making this up. For all the things the Federal Reserve was doing for presumably liquidity and stability, they ended up creating a large amount of bank reserves. And as money rates tumbled, officials connected the one to the other.

For the first time in history, a worldwide bank panic alongside an overabundance of cash. You’re probably scratching your head at this point. At least that’s what they tried to say, and still claim to this very day. The doctrine of “ample” or “abundant reserves.” They may have been abundant but that only goes on to establish how they must have been, and continue to be, largely irrelevant.

The Fed wasn’t entirely powerless, though. During September 2008, the central bank undertook billions in reverse repos while also working out an arrangement with the Treasury Department to essentially create off-the-books Treasury securities (Supplementary Financing Account). A reverse repo is the same repo transaction from the perspective of the other side; the Fed “borrowing” cash from the market on collateral of UST instruments it holds in SOMA.

The cash was coming in, the securities going out.

But Bernanke wasn’t doing these things to alleviate the collateral squeeze, he was doing them because the federal funds rate kept coming in way, way underneath the Fed’s policy target. Again, these people thought there was too much cash! During a global bank panic they couldn’t stop!

Both the reverse repos as well as the SFA were designed and intended to “soak up” all those supposedly “excess” reserves. FRBNY’s press release announcing the program explicitly stated as much: “Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”

In other words, it was quite by accident that the Fed added a little more collateral back into a system desperately starved of it. Because the central bank was responding to its perceptions of its mandate in terms of “reserves”, the inelasticity in collateral would continue. As would the panic.

By the second week in December 2008, repo fails were still more than $600 billion. The middle week, the one during which the FOMC voted for ZIRP, near $900 billion yet again.

On December 9, 2008, the federal government auctioned off $30 billion in 4-week bills at a calculated yield of ZERO. Some of those securities were overbid, meaning that they yielded to the buyer a negative return.

Back to that Financial Times article; were the negative yields responsible for the mess in repo and collateral, the disincentive for dealers to intermediate? Or were the negative and zero yields an indication of demand for collateral perhaps even among the dealers themselves?

Remember, this was December several months into the paradigm of “abundant reserves.” And it was the cusp of the Fed’s QE, the “money printing” Ben Bernanke was always too happy to let you believe he would undertake (but didn’t; QE was never money printing, it was a misleading extension of the “ample reserves” framework). The crisis would continue for another three months, by then more than 7 million Americans thrown out of work for reasons they still don’t know.

What were we missing?

Short answer: securities lending. A repurchase agreement sounds easy and terrific. And these are done occasionally worldwide on a DVP basis; that is, delivery versus payment. You borrow cash from me, I get a UST as collateral from you, and both are exchanged one-for-one via a custodian.

But in common eurodollar practice, especially in some of those vast, undiscovered offshore spaces, you borrow cash from me as I borrow a UST from you, as you may have borrowed the thing yourself. We are both borrowers and lenders, but of different things with often the same purpose. The one is more powerful and useful than the other; collateral over cash. That’s why its inelasticity mattered a whole lot more than any elasticity in terms of bank reserves.

Securities lending is essentially the fiat nature of collateral which acts as its own kind of currency. Another misconception of the crisis: AIG was bailed out because of its credit default swaps. No. It nearly failed because of its securities lending practices, as I wrote last year:

“One of AIG’s insurance subs would lend securities to another special purpose subsidiary, AIG Global Securities Lending. Acting as agent, this latter firm would then relend the same securities to banks and broker dealers who had created a need for them in burgeoning repo, derivatives, and offshore FX markets. 

“These banks or brokers would deposit cash with AIG Global Securities Lending as collateral for the securities. Cash was collateral for the collateral they sought (see what I mean about capitalism).”

While AIG would then use that cash to invest unwisely in subprime mortgages and other risky forms of junk, the firm’s real problem was the liquidity bottleneck this process of collateral “transformation” had created. While specifically leading to its own near demise, those other dealers lining up to “borrow” this already-borrowed AIG collateral had undertaken similar designs.

The idea of detached money dealers running matched books is a fiction, demonstrated not just by AIG but also a few others you’ve heard about – Bear, Lehman – and probably a few more you didn’t or have forgotten – Dexia, MF Global.  In other words, a dealer isn’t always just standing in the middle of two other repo counterparties matching demand for collateral with its supply. They often straddle the line on either side, making bets as to which way is the most profitable – and taking risks by doing so.

They aren’t just making money off the minute spread in repo; they never made much money off the spread to begin with. They have, as I said, a better than front row seat for collateral flow because they aren’t just in the audience dispassionately watching the repo theater unfold.

AIG may have been an insurance company, but AIGGSL was more so a money dealer.

Let’s go back to Bernanke again testifying to Congress in late September 2008. What did he tell both the House and Senate about AIG?

“In the case of AIG, the Federal Reserve, with the support of the Treasury, provided an emergency credit line to facilitate an orderly resolution.  The Federal Reserve took this action because it judged that, in light of the prevailing market conditions and the size and composition of AIG's obligations, a disorderly failure of AIG would have severely threatened global financial stability and, consequently, the performance of the U.S. economy.”

Sure, but what does that really mean? Another question never asked. AIG was handled in an orderly fashion, and what good did it do? Functionally, how was AIG really connected to everyone else? In what actual capacities did the “size and composition of AIG’s obligations” impact the entire global financial system?

Credit default swaps were one thing, yes, but what do you think happened when AIGGSL could no longer supply collateral to the marketplace via its transformation archetype?

And it wasn’t just AIG, obviously. Other dealers who were doing similar things clamped down on them, too. The size, fluidity, and flexibility of the systemic collateral pool were all negatively impacted. Therefore, $5 trillion in repo fails while the mainstream media focused on subprime mortgages and the S&P 500.

But, as I wrote before, back then there were few if any answers. Who had ever heard of repo? The Bernanke’s of the world didn’t talk about it, and with his and other’s “abundant reserves” they mentioned it even less, if that was possible. Many experts even by December 2008 were more concerned with how what they saw as a quaint repo mechanism could harm the federal government’s ability to finance its ballooning deficits. They worried interest rates were going to rise quickly, as if that was the big thing upon which to focus everyone’s attention as it related to repo.

Repo collateral, global funding in dollars, ineffective central bank. Here we are again with the same issues, if not quite to the same level. Over the last several weeks since mid-October 2019, I will point out, primary dealer holdings of T-bills have skyrocketed.

Now eleven years after the “somehow” Global Financial Crisis, you might (correctly) surmise that the appropriate lessons haven’t yet been learned. That repo remains largely a mainstream mystery, not just in the sense of the public’s lack of awareness but also that of policymakers. Once more they promise ample or abundant reserves (Not-QE) and voice how these are necessary if only to keep Treasury yields from jumping.

If only those were our real concerns. Maybe if someone could “address dollar funding pressures worldwide” and do it right with some understanding of collateral. We aren’t going to repeat 2008, but that doesn’t mean repo problems and their main part in an ever-growing global dollar shortage won’t cause what is really serious and unnecessary harm.

How is it that the US again flirts with something like recession? Bad enough, check out other parts of the world like China and India.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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