The Fed is holding a significant amount of assets on its books in the form of Treasuries. For example, the Fed has purchased an enormous amount of US Treasury issuance in the past six months as part of its quantitative easing program, aka monetization. It has also taken on tranches of mortgage debt obligations from the banks, purportedly to improve the banks capitalization profile because of the dodgy nature of the assets.
This has added significant short term liquidity to the system, much of it held by the banks for interest at the Federal Reserve itself.
At some point the Fed will wish to reduce the levels of liquidity in the system. One way to do this is by increasing interest rate targets. It can achieve this, for example, by increasing the amount it pays for reserves.
The traditional way for the Fed to drain liquidity is to conduct what is known as a reverse repurchase agreement, or reverse repo.
In a normal repurchase agreement or repo, the Fed purchases assets held by the banks, normally Treasuries, which obviously increases the 'cash' being held by the bank. A repurchase agreement is by definition for a specific amount of time. At the end of the period the Fed sells the asset back to the bank. The difference in amounts is the 'interest' which changes hands for the transaction.
There is also a type of purchase agreement with no buyback. It is known as a PMO, or Permanent Market Operation. These are used to add liquidity as the name implies, permanently.
A reverse repo is just the opposite. In this case, the Fed sells an asset from its balance sheet to an institution for 'cash' and thereby drains or takes cash liquidity out of the system.
Aren't Treasuries as good as 'cash?' Why does it matter whether a bank is holding Treasuries or cash on its books? Apparently not the case, at least for accounting and regulatory purposes. Remember that the next time someone tells you that banks do not need depositors. Sometimes they do.
Typically the Fed has only done this type of operation with a group of about twenty or so financial institutions known as the Primary Dealers.
According to this news piece, the reason the Fed is looking to the Money Markets is that, just like Willie Sutton, that's where the money is. There, and in the 401k's, and the IRA's.
The central bank is now considering dealing with money market funds because it does not think the primary dealers have the balance sheet capacity to provide more than about $100 billion... Money market mutual funds have about $2.5 trillion under management..."
To digress, please note that somewhat startling statistic. The Fed is going to the money market funds, because they think that the primary dealers among them cannot raise more than $100 billion dollar in liquid capital to take repos from the Fed, without impairing the banking system. If you look it up in the dictionary, try looking under 'fragile' or 'insolvent.'
Back on topic, there has been a longtime animosity between the banks, or at least what used to pass as a bank, and the money market funds. The funds are not covered by FDIC, are not regulated as banks, and typically pay higher rates of interest to depositors than conventional commercial banks. They tend to invest their funds in the commerical paper markets. It was the seizure of the short term paper markets that brought the money market funds to the brink, and a potential run on the funds, as fears grew that they would 'break the buck,' that is, the Net Asset Value of One Dollar for every dollar deposited.
Obviously this entire proposition is a bit puzzling on the surface, and is certain to raise fears of Fed shifting toxic assets from the banking system to the more 'public funds.' It is not a huge concern if these are truly repurchase agreements since the value of the assets will be backed 100 percent by the Fed. We would also assume that the Funds might be able to express some preference for Treasuries, rather than bundles of sludge backed by Joe Subprime Sixpack LLC.
It was also interesting today that in his testimony before the Congress which was widely ignored by the mainstream media, Paul Volcker had some very strong words about what is a bank, and what is not. Money market funds are not banks, and banks have no business using their banking platforms to fund proprietary trading operations that are merely seats at a rather risky virtual casino known as Wall Street.
We admit now as before that we do not fully understand the accounting system of the banking industry, having grown up on the productive side of the economy, but are learning quickly.
One thing we can judge is character, and the character of many of the actors on this stage appear to be less than trustworthy to say the least, especially in the Obama Administration and their cronies on Wall Street. In reviewing the biographies of many of the key players, we were struck by how few of them have ever done anything, built anything, in the productive economy. Its all about FIRE institutions and governments, and revolving doors where one is paid for connections and influence, and following orders.
Increasingly it seems that the Wall Street financial institutions, led by the gang of four, will push their power grip on the nation until something stops them. What that will be, no one can know for sure. The Ponzi scheme they have been running is starting to fall apart. The target bag holders, the Chinese, Japanese, and Europeans seem to be slipping towards the exit. When the music stops, someone may be left with a big pile of worthless paper. It looks to us like the Fed is interviewing candidates.
And this is why we say:
The banks must be restrained, and the financial system reformed, and the economy brought back into a balance between the productive and administrative sectors, before there can be any sustained recovery.
Fed's exit strategy may use money market funds
Thu Sep 24, 4:02 am ET
LONDON (Reuters) – The U.S. Federal Reserve is studying the idea of borrowing from money market mutual funds as part of eventual steps to withdraw stimulus, the Financial Times reported on Thursday.
The Fed would borrow from the funds via reverse repurchase agreements involving some of the huge portfolio of mortgage-backed securities and U.S. Treasuries that it acquired as it fought the financial crisis, the newspaper reported, without citing any sources.
This would drain liquidity from the financial system, helping to avoid a burst of inflation as the economy recovered.
The FT said Fed officials had in recent days held discussions with market participants on how it might implement such a scheme.
The Fed is considering whether to conduct a pilot scheme, but worries such a test might be seen as a signal that the central bank was about to drain liquidity on a large scale, the newspaper said. In the near term, a big drain remains unlikely, it added.
The central bank held interest rates at close to zero on Wednesday and upgraded its assessment of the U.S. economy, saying growth had returned after a deep recession.
The Fed also said it would slow its purchases of mortgage debt to extend that program's life until the end of March, in a move toward withdrawing the central bank's extraordinary support for the economy and markets during the contraction.
The idea of the Fed using reverse repos to help unwind policy is not new; Fed chairman Ben Bernanke identified them as a potential means of soaking up liquidity in July. But the market had previously expected the repos to be done with primary dealers, including former Wall Street investment banks.
The central bank is now considering dealing with money market funds because it does not think the primary dealers have the balance sheet capacity to provide more than about $100 billion, the Financial Times said.
Money market mutual funds have about $2.5 trillion under management so they could plausibly provide between $400 billion and $500 billion, it said.
The newspaper added that the Fed did not think it would need to drain liquidity all the way to where it was before the crisis, because it was confident it could raise interest rates even with a much larger amount of reserves in the system than existed before the crisis.