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November 02, 2019

Liquidity Crisis 2.0?

It looks as though we may be seeing a repeat of conditions that foreshadowed the 2007–2008 financial meltdown.

 “In summer 2007, U.S. and global financial markets found themselves facing a potential financial crisis, and the U.S. Federal Reserve found itself in a difficult situation. It was becoming clear that banks and other financial institutions would ultimately lose tens or even hundreds of billions of dollars from their exposure to subprime mortgage market loans….

When this kind of event happens, the job of the central bank is to assure that financial institutions have the necessary funds to conduct their daily business; that they have the “liquidity” they need to make timely payments and transfers. Modern financial institutions need to replenish their funding every day. In the United States alone, literally trillions of dollars are transferred between banks each day to support the $50 trillion credit outstanding in the economy as a whole.…

In fall 2007, the Federal Reserve provided short-term funding liquidity by, in effect, allowing banks to exchange their holdings of Treasury securities for cash. This policy enabled the banks to meet the credit line commitments they had outstanding.” Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis (2009) https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.23.1.51

On Sept. 17, 2019, for the first time in nearly a decade, the Federal Reserve began propping up the overnight repurchase agreement (repo) market by injecting huge sums of government money into the system to ensure that banks have enough cash to continue operating and lending to their own customers.

How does this work? The overnight repurchase market is where banks (particularly the big banks) can borrow money that they, in turn, use to make loans to consumers and businesses. Large money market funds, for example, and banks can invest their own deposits in the overnight repo market. They make money by lending these funds to other financial institutions on a short-term basis, often just overnight.

When money market funds lend the banks cash, the banks pay interest on these loans — usually a target rate that the Fed sets. Until recently, that rate has been around 2%. As collateral for these short-term loans, the borrowing banks will put up U.S. Treasury bills and other securities until the loans are repaid.

When the market functions normally, the lending money market funds and financial institutions place their funds into the repo market, providing sufficient capital to meet the needs of the banks that want to borrow.

In mid-September 2019, however, insufficient cash was deposited into the overnight repo market for all the banks that wanted to borrow money. This cash shortage caused the overnight interest rate to skyrocket to 10% — way above the Fed’s target rate. This is what is referred to as a liquidity crisis.

Worryingly, no one seems to be able to agree on the exact reasons for this liquidity crisis. It is thought that the reduction in the amount of cash reserves banks are required to hold is partly responsible.

When the Fed pumped $53 billion into the banking system to keep it going on Sept. 17, it blamed one-time events for the problem:

Fed officials initially blamed one-off events: The withdrawal of cash by US companies to make quarterly tax payments to the Treasury Department and the settlement of a large amount of Treasury purchases. Both those factors have since passed. https://www.cnn.com/2019/10/25/business/overnight-lending-market-federal-reserve/index.html

Initially, the market seemed to settle down. But then the interest rate shot up again on Oct. 22, prompting the Fed to pump even larger sums ($99 billion a week ago Tues. and another $134.2 billion on Thursday) into the system.

But even as the Federal Reserve’s spokespeople continue downplaying the seriousness of the situation, the Fed also has stated that it will continue propping up the repurchase market at least through then end of the 2019. The Fed began quantitative easing (buying collateral — Treasury bills and bonds — to inject more cash into the system) in 2007 and only began reversing course to shrink its balance sheet last year (quantitative tightening).

How significant is this reversal? Without fully understanding the causes, it’s difficult to know for sure. But here is Sven Henrich’s (founder and chief strategist for NorthamTrader) take:

I'll go out on a limb here, but a financial system that requires over $100B of liquidity injections every day, temporary, permanent or otherwise, has major issues. 1:07 PM - 23 Oct 2019

The repurchase market represents only a small part of the system, but its dysfunction is disquieting and goes to show how vulnerable the financial system still is.