US funding chaos a sign of trouble?

THERE was concern over US funding chaos recently and the size of Federal Reserve intervention as such a scale of capital injection had not been undertaken since 2008.

In the short term, the New York Fed had managed to calm the money markets and lowered overnight borrowing costs by injecting massive amounts of money via repurchase agreements (repos).

Could this cash crunch among banks and other borrowers signal an underlying problem that can lead to an erosion of confidence?

In the week of Sept 16, banks did not have enough ready cash to lend to each other for short term purposes. Interest rates in the overnight lending market spiked, a reminder of a similar situation before the 2008 financial crisis. Rates hit 10% in the repo market, and breached the upper limit of 2% to 2.5% target range of the federal funds rate.

In the repo markets, a form of short term borrowing mainly in government securities, is carried on, where an underlying security is sold and bought back shortly afterwards.

The Fed had to double up by offering repos and pumping in Us$200bil as short term cash payments to borrowers over three days; it plans for further injections of at least US$75 billion daily until October 10.

Besides having to settle bills, quarterly tax payments, and Us$78bin in payment for Treasury notes and bonds, banks may be keeping aside cash to protect against potential losses. Bank reserves at the Fed had fallen by 50% to US$1.47 trillion from a peak of US$2.8 trillion five years ago. This cash crunch could be due to a technical reason; what happened in 2008 which led to a systemic financial crisis may not recur yet.

Back then, insolvent institutions with distressed assets went into the repo market; rates had spiked to 10%. Investors then were worried about the financial health of banks, which are stronger now. In the 2008 situation, lenders had demanded cash from borrowers as they did not trust the quality of the collaterals. Liquidity dried up and borrowers, in need of cash, sold off their securities in massive fire sales. The panic spread to the stockmarkets.

Currently, there are a lot of leveraged buyers of US government bonds and yield levels need to adjust to attract non-leveraged players. Eventually, liquidity should come back to markets or the Fed will use more permanent methods to increase system liquidity, thus easing liquidity conditions,’’ said Hong Leong Bank chief operating officer, global markets, Hor Kwok Wai.

Regulatory reforms now require US lenders with assets exceeding US$250 billion to keep highly liquid assets on their balance sheets. This restricts the ability of banks flush with money to lend, while the Fed too may have tightened its balance sheet too rapidly.

The effects of quantitative tightening are starting to play out in the reduction of liquidity in the market; the Fed had stopped rolling over its bond buying stimulus, right through December last year, into July. At the same time, the Treasury Department, faced with a US$1 trillion budget deficit this fiscal year, was issuing higher amounts of monthly bond auctions.

Now that the debt ceiling limiting the amount of debt that can be borrowed, is lifted, new government debt had also come in. Japan and China, which have large stakes in Treasuries, have seen their holdings close to the lowest in at least 20 years and the lowest since mid-2006 respectively. US commercial banks have ended up with a record amount of Treasuries and agency securities of notes and bonds issued by government sponsored enterprises.

It must be realised that the Fed has calculated there should be excess reserves; the suspicion is that lenders may be ‘hoarding’ the liquidity for fear of non-repayment, said Inter-pacific Securities head of research Pong Teng Siew.

“If this loss of confidence is the reason for the clogged flow in funding, we can face a situation that is similar to what happened in 2008,’’ Pong said.

It is a sign of problems that the Fed has to persistently add such massive amounts of liquidity into the system, and the potential for a systemic event in the US has gone up.

“The Fed might have under-estimated the amount of cash needed to keep the financial system operating smoothly,’’ said Ambank Research head Dr Anthony Dass.

If this upward trend in repo rates persists, it will cause problems. There is room for more Fed action including additional Fed operations, besides monetary easing.

Today will be closely watched, it is the last day for end of quarter payments, with settlement for Us$113bil in Treasury auctions from Tuesday to Thursday.