“Central Banks are panicking…the whole system is on the verge of disappearing into a black hole.” – Egon Von Greyerz on USAWatchdog.com
On Wednesday, after Wednesday’s overnight Repo operation had $92 billion in demand for the $75 billion operations, announced that it was increasing overnight Repos to $100 billion and doubling the two-week term Repo operations to $60 billion. Well, that escalated quickly.
The rationalization is “end of quarter liquidity needs” by the banks who have to increase reserves against assets (loans) or face taking earnings write-downs. But this dynamic occurs every quarter and Repo operations have not been required to keep the banking system from seizing up since QE was initiated.
Note that overnight repo operations were not necessary when the Fed flooded the banking system with QE funds. The banking system requires immediate liquidity for the first time since QE commenced. Why? Recall how you go bankrupt: gradually then suddenly.
Typically the repo rate should correlate tightly with the Fed Funds Rate. But last Tuesday it spiked up briefly to 10%. The media and Wall Street analysts did a good job reporting that there was an obvious liquidity squeeze in the banking system but they did nothing to explain the underlying causes. Moreover, there’s still $1.3 trillion remaining from QE sitting in the Fed’s Excess Reserve Account, which means banks with cash have plenty of cash to lend overnight to banks which need money.
But the banks with cash were unwilling to lend that cash even on an overnight basis. So why did the Fed have to inject, by last Wednesday, $75 billion in liquidity into the banking system?
Think about what happened as the start of a giant “margin call” on a global financial system that is likely reaching its limit on credit creation. The enormous increase in derivatives magnifies the problem. One immediate contributing factor may been losses connected with the cliff-dive in the price of the 10yr Treasury bond. Hedge funds loaded up on Treasuries chasing the momentum higher using margin provided by the banks (prime brokerage loan agreements). The 10yr Treasury price dropped $4 in eight trading days – i.e. the 10yr benchmark yield jumped 55 basis points.
This may not sound like a lot in stock price terms, but losses on speculative Treasury bond and Treasury bond futures positions likely ran into the billions. Several entities lost a lot of money during that rate rise, which means there had to have been some margin calls and derivatives blow-ups which required cash collateral or faced liquidation. Banks themselves carry large Treasury positions which fell $10s of millions in value over that 8-day period.
In addition to losses on Treasury bonds, I’m certain there’s been a general erosion of bank assets – primarily debt-based securities and loans, which have led to enormous losses when Credit Default Swap derivatives are factored into the mix. In effect, there likely was a large systemic margin call which has created a cash and collateral squeeze in the banking system with the primary dealers, which is why the overnight funding mechanism required a cash injection by the Fed eight days in a row now. This is similar what happened in 2008.
For now the Fed is going to plug the funding gap at the banks with these Repo operations. But my bet is that the problem is escalating rapidly. It is much bigger in aggregate globally than anyone can know, just like in 2008. In all probability the Fed has no clue how big the potential problem is and these Repo operations will eventually morph into outright money printing.