High Plains Drifter?
October 30th FOMC actions - FFR -25bps to 1.50%-1.75%; IOER -25bps to 1.55%; o/n repo -25 bps to 1.45; primary credit rate -25bps to 2.25%
Our unprecedented in depth coverage of the repo ruckus continues, following up on The Man With No Name in Part 8: Blood For a Dirty Dollar?
With the High Plains Drifter in mind, UST bills are the "creme de la creme" in balance sheet lite collateral, specific to providing liquidity in REPO transactions which form collateral chains. For this portion of our discussion focus on...
Repo, collateral, and carry trades synthetically arbed through derivatives involving maturity and collateral transformation, and what could happen if the trade suddenly went the wrong way. Now think of the following market drifters (neither short and by no means comprehensive)....
Dealer financing of corporate debt securities, much of which is facilitated via short term repurchase agreements (repos). Less liquid junk bonds or leveraged loans held by open end investment vehicles such as mutual funds or by exchange traded funds (ETFs). Agency REITs which buy agency mortgage backed securities (MBS), and fund them largely in the short term repo market in a levered carry trade.
Mandated regulatory capital requirements (LCR, GSib SLR). Window dressing, pension funds and other participants wishing to increase their reported returns with securities lending income, without changing the holdings reported on balance sheet.
Long term low interest rates which encourage yield chasing, by taking on longer duration and mis priced risk (distorted spreads, miscalculated Var) through additional leverage. As the yield curve steepens, how a bank can boost its reported income by replacing low yield short duration securities with higher yield long duration securities. Vice versa as the yield curve inverts, replacing low yield long duration with higher yield short duration.
Maturity and collateral transformation with less desirable collateral (already haircut), which can decline in value causing collateral chain margin calls. Balance sheet shenanigans viz. mismarking of derivatives losses and misstatement of losses in off shore custody SIV's (CDO and CLO).
What could go wrong? Many of the above could lead to potential margin calls, and ill-liquidity in unwinding risky collateral chains tied to synthetic (derivative) maturity and collateral transformation carry trades. For the duration of this missive focus on... to know money from mud, one must know the difference in stock vs flow, and a debit from credit. And now as previously promised...
The qualifiers inside and outside refer to the asset counterpart of the money (IOU). In the case of fiat money liability, there need not be a counterpart on the assets column of the government’s balance sheet. Manna dat you?
Another distinction, whether assets or liabilities constitute inside money depends on whether they circulate as means of payment viz bonds held to maturity are not. Tricky? To determine whether inside or outside, lets look at the other side of the ledger, where the liability lies, the money lies. Pun intended. Stylized example...
Private bank deposits are liabilities inside the private system, hence inside money. In the case of QE, those bank reserves are deposits which are FRB liabilities credited to the primary dealers outside the private system, hence outside money. Simplified for our purposes...
Fed FRB's + 24 Primary Dealers (Commercial Banks) = Outside Money (backed by fiat debt)
All Others (customers of those CB's) = Inside Money (backed by private debt)
Thus, whereas QE POMO's between the Fed and NON commercial banks (the commercial banks customers) would expand the inside money (private sector) supply, QE between the commercial banks (primary dealers) and the FRB's is an asset swap (UST bills for FRB credit in the form of reserves) which expands outside money. And now as previously promised and with those distinctions fresh in mind, paraphrased from one of our mentor's...
The remuneration rate (IOER) on interbank demand deposits (reserves parked at the FRB) is a central bank credit control device, the influence of which is focused on the relentless front end churn and turn of the wholesale funding money market.
Above since March 20, 2019 IOER (outside rate) has been below EFFR (inside rate). Prior to that day and ever since the GFC in 2008, IOER had been ABOVE EFFR and for a large portion of that decade, most short term inside money rates. This condition created a transposition of the savings investment channel.
Not so fast Joe, or you finish outside? When the return on inside money (typically short duration) is less than outside money (IBDD or IOER), where does the money gravitate? Yield, so those flows have little pass through to spur the inside economy, as the money goes outside.
NIM compression already leads to chasing yield in unstable alternatives to deposits viz. substitution for insured deposits. Recent reductions in IOER might have spurred some actors to dabble elsewhere with their ample reserves, with unintended consequence? Perhaps why all three EFFR and SOFR based upon REPO have been less than stable since March 20th?
There is something in this more than natural. With IOER below REPO, why are so many (including MMF's, Hedge Funds, GSE's, NB's) unwilling to take the risk of handling "safe" UST's? What part of "for profit" did they suddenly forget?
Something is rotten in Denmark. Is counterparty and/or collateral risk causing market maker disintermediation? Perhaps somebody (Jamie Gang) spoon fed on IOER pabulum has become overly dependent? and wants to blackmail the sheriff into turning the alphabet soup of capital requirements into the Wild Wild West again? Maybe everybody knows about the BS (balance sheet?) collateral that the other guys are really packin in their wallet?
With advertised unemployment at 3.5% along with mortgage rates, the contagion of Fed narrative has gone from, robust and best in 50 years to... preemptive one and done cut to... cessation of balance sheet runoff to...
three 25 bps "mid cycle" cuts to... temporary repo market intervention to... long term POMO market making intervention to... QE expansion of the balance sheet by 250 bln per quarter? Excuse me but how many excuses does Jerome and The Jackson Hole Eleven have for Organic BS (balance sheet) growth? No problems? Business as usual? Worry not?
Is there something off balance sheet that is in offshore custody, perhaps exposed through collateral transformation to junk CLO or leveraged loans? Involved in carry trades not unwinding on the backside as planned? Is somebody duration mismatched and can't roll over their short term debt fast enough?
Who is left to pick up the pieces of flotsam, jetsam, lagan and derelict in this Sargasso sea of a repo market? You mean without the Fed sheriff behind the window for the last 45 days, our chances of making repo are slim and none, and Slim just left town?
More to come as the Man With No Name returns in Part 10: Pale Rider? Stay tuned, no flippin.
Recommended Reading:
A Fistful Of Dollars?
For A Few Dollars More?
The Good, The Bad And The Ugly?
A Coffin Full Of Dollars?
A Dollar To Die For?
The Devil's Dollar Sign?
The Million Dollar Bloodhunt?
Blood For a Dirty Dollar?
A Negative Disposition?
A Wayward Italian in Kansas?
First Rule Of Bond Market: You Do Not Talk About Keynes?
Half Baked Hopes Souffle?
Inside and Outside Money - Minneapolis FRB
Overheating in Credit Markets: Origins, Measurement, and Policy Responses
Our unprecedented in depth coverage of the repo ruckus continues, following up on The Man With No Name in Part 8: Blood For a Dirty Dollar?
Like cash notes and specie, outside money expands when the Fed credits the dealer banks with reserves at the FRB that didn't previously exist. Ex nihilo, manna from heaven?In Part 9, when suitable replacement cannot be sourced, not even manna from heaven can help the many left adrift in the market, and... they'd never forget the day he drifted into town.
Repo, collateral, and carry trades synthetically arbed through derivatives involving maturity and collateral transformation, and what could happen if the trade suddenly went the wrong way. Now think of the following market drifters (neither short and by no means comprehensive)....
Dealer financing of corporate debt securities, much of which is facilitated via short term repurchase agreements (repos). Less liquid junk bonds or leveraged loans held by open end investment vehicles such as mutual funds or by exchange traded funds (ETFs). Agency REITs which buy agency mortgage backed securities (MBS), and fund them largely in the short term repo market in a levered carry trade.
Mandated regulatory capital requirements (LCR, GSib SLR). Window dressing, pension funds and other participants wishing to increase their reported returns with securities lending income, without changing the holdings reported on balance sheet.
Long term low interest rates which encourage yield chasing, by taking on longer duration and mis priced risk (distorted spreads, miscalculated Var) through additional leverage. As the yield curve steepens, how a bank can boost its reported income by replacing low yield short duration securities with higher yield long duration securities. Vice versa as the yield curve inverts, replacing low yield long duration with higher yield short duration.
Maturity and collateral transformation with less desirable collateral (already haircut), which can decline in value causing collateral chain margin calls. Balance sheet shenanigans viz. mismarking of derivatives losses and misstatement of losses in off shore custody SIV's (CDO and CLO).
What could go wrong? Many of the above could lead to potential margin calls, and ill-liquidity in unwinding risky collateral chains tied to synthetic (derivative) maturity and collateral transformation carry trades. For the duration of this missive focus on... to know money from mud, one must know the difference in stock vs flow, and a debit from credit. And now as previously promised...
Another distinction, whether assets or liabilities constitute inside money depends on whether they circulate as means of payment viz bonds held to maturity are not. Tricky? To determine whether inside or outside, lets look at the other side of the ledger, where the liability lies, the money lies. Pun intended. Stylized example...
Private bank deposits are liabilities inside the private system, hence inside money. In the case of QE, those bank reserves are deposits which are FRB liabilities credited to the primary dealers outside the private system, hence outside money. Simplified for our purposes...
Fed FRB's + 24 Primary Dealers (Commercial Banks) = Outside Money (backed by fiat debt)
All Others (customers of those CB's) = Inside Money (backed by private debt)
Thus, whereas QE POMO's between the Fed and NON commercial banks (the commercial banks customers) would expand the inside money (private sector) supply, QE between the commercial banks (primary dealers) and the FRB's is an asset swap (UST bills for FRB credit in the form of reserves) which expands outside money. And now as previously promised and with those distinctions fresh in mind, paraphrased from one of our mentor's...
The remuneration rate (IOER) on interbank demand deposits (reserves parked at the FRB) is a central bank credit control device, the influence of which is focused on the relentless front end churn and turn of the wholesale funding money market.
Not so fast Joe, or you finish outside? When the return on inside money (typically short duration) is less than outside money (IBDD or IOER), where does the money gravitate? Yield, so those flows have little pass through to spur the inside economy, as the money goes outside.
NIM compression already leads to chasing yield in unstable alternatives to deposits viz. substitution for insured deposits. Recent reductions in IOER might have spurred some actors to dabble elsewhere with their ample reserves, with unintended consequence? Perhaps why all three EFFR and SOFR based upon REPO have been less than stable since March 20th?
There is something in this more than natural. With IOER below REPO, why are so many (including MMF's, Hedge Funds, GSE's, NB's) unwilling to take the risk of handling "safe" UST's? What part of "for profit" did they suddenly forget?
"Last year, we had more cash than we needed for regulatory requirements, so repo rates went up, we went from the checking account, which was paying IOER, into repo. Obviously makes sense, you make more money." - Jamie Dimon BloombergOh wait, there it is... the signpost up ahead: maybe there is not enough profit in the deal to take the risk, because market price, discovery and risk are distorted? Maybe somebody decided it's time to put down the debt laden fork, risk plagued knife and back away from the low return high risk table?
Something is rotten in Denmark. Is counterparty and/or collateral risk causing market maker disintermediation? Perhaps somebody (Jamie Gang) spoon fed on IOER pabulum has become overly dependent? and wants to blackmail the sheriff into turning the alphabet soup of capital requirements into the Wild Wild West again? Maybe everybody knows about the BS (balance sheet?) collateral that the other guys are really packin in their wallet?
With advertised unemployment at 3.5% along with mortgage rates, the contagion of Fed narrative has gone from, robust and best in 50 years to... preemptive one and done cut to... cessation of balance sheet runoff to...
three 25 bps "mid cycle" cuts to... temporary repo market intervention to... long term POMO market making intervention to... QE expansion of the balance sheet by 250 bln per quarter? Excuse me but how many excuses does Jerome and The Jackson Hole Eleven have for Organic BS (balance sheet) growth? No problems? Business as usual? Worry not?
Is there something off balance sheet that is in offshore custody, perhaps exposed through collateral transformation to junk CLO or leveraged loans? Involved in carry trades not unwinding on the backside as planned? Is somebody duration mismatched and can't roll over their short term debt fast enough?
Who is left to pick up the pieces of flotsam, jetsam, lagan and derelict in this Sargasso sea of a repo market? You mean without the Fed sheriff behind the window for the last 45 days, our chances of making repo are slim and none, and Slim just left town?
More to come as the Man With No Name returns in Part 10: Pale Rider? Stay tuned, no flippin.
Recommended Reading:
A Fistful Of Dollars?
For A Few Dollars More?
The Good, The Bad And The Ugly?
A Coffin Full Of Dollars?
A Dollar To Die For?
The Devil's Dollar Sign?
The Million Dollar Bloodhunt?
Blood For a Dirty Dollar?
A Negative Disposition?
A Wayward Italian in Kansas?
First Rule Of Bond Market: You Do Not Talk About Keynes?
Half Baked Hopes Souffle?
Inside and Outside Money - Minneapolis FRB
Overheating in Credit Markets: Origins, Measurement, and Policy Responses
Comments
re "There is something in this more than natural. With IOER below REPO, why are so many (including MMF's, Hedge Funds, GSE's, NB's) unwilling to take the risk of handling "safe" UST's? What part of "for profit" did they suddenly forget?"
and re "Is there something off balance sheet that is in offshore custody, perhaps exposed through collateral transformation to junk CLO or leveraged loans? Involved in carry trades not unwinding on the backside as planned? Is somebody duration mismatched and can't roll over their short term debt fast enough?"
I really wonder if we got a hidden Lehman-like situation festering in the whole banking system re USTs. That is, we know that (money center and shadow) banks have been rehypothicating UST. However, no one (except the dealer banks) seems to know to what degree. I'm seeing some evidence that USTs are being rehypothecated (e.g., in repo’s, swaps, etc.) at alarmingly high rates. If so, then maybe the reason banks are staying away from apparently very profitable debt/asset swap trades is that they don’t trust the counterparty’s USTs to not be already spoken for (many times over!). Remember MF global w/ gold rehypothecation??? Like Buffet says, only when the tide drops do you discover who is swimming naked. In this scenario, USTs would be toxic assets and could freeze up the bank-to-bank transactions, blowing out spreads, and the Fed would have to buy/guarantee bogus (rehypothicaed) UST claims, which become invalid in bankruptcy. Effectively, we could be staring down the barrel of a massive banking system bail out needed, which would vastly expand the Feds balance sheet to include toxic/fake UST assets. Of course, those would get monetized too. In any case, the effective Fed’s true balance sheet via FDIC on toxic/fake UST assets could be huge, and as banks get afraid they’ll tighten their standards on counterparty risk, and we’d start seeing spreads widen. Maybe this is what happened in the last repo spreads blow out and what is keeping banks w/ lost of USTs out of the repo market? The Fed cannot afford any kind of recession b/c they’d learn many counterparties are swimming naked and the system blows up. BTW, China is like doing many times the level of rehypothecation as the US, so to me, these are black swans with a *fat* tail risk here. What do you guys think? Everyone on SA has be very silent on this subject.