August 10, 2007
What is a liquidity event?
It was an exciting week in financial markets, including some dramatic central bank interventions in short-term money markets.
First, a little background on what we're talking about here, focusing on the U.S. system with which I am most familiar. Banks that are members of the U.S. Federal Reserve System hold accounts known as Federal Reserve deposits. These deposits play a fundamental role in interbank financial transactions. If a bank wants more currency, it can obtain it by converting its Federal Reserve deposits to cash. Checks are often cleared by debiting the Federal Reserve deposits of the bank on which the check is drawn and crediting those for the receiving bank. Wire transfers are also implemented by a transfer of deposits between banks.
If you followed an individual dollar of Federal Reserve deposits, you would find it moving between banks a very large number of times each day. However, none of these interbank transactions would change the total value of Federal Reserve deposits. New deposits can only be created by an act of the Fed itself, either in the form of an open market operation (in which the Fed credits a particular bank with new deposits in exchange for receipt of another asset of equal value) or a discount window loan (in which the Fed loans deposits to the bank, holding other assets from the bank as collateral).
Banks try to hold as few of these deposits as possible, since they do not pay interest. However, banks are required to hold minimum levels of deposits based on the dollar value of checking accounts issued. Banks could alternatively meet some of these requirements by holding physical cash instead, and the sum of this cash plus deposits is known as reserves.
The banking system as a whole usually holds only a small amount of reserves in excess of what is required. A bank that ends up with extra reserves would find it advantageous to loan Federal Reserve deposits overnight to a bank with a deficit in what is called the federal funds market. The interest rate on these overnight loans is usually very sensitive to the quantity of excess reserves in the system, so the Fed could change this rate by adding or subtracting deposits through open market operations. The Fed simply announces the rate it intends to maintain, with the current target being 5.25%, and the announcement is credible because all participants know that the Fed will be adding or draining reserves as necessary to keep the rate near the target.
Not all loans will take place exactly at the target rate, however. These loans are unsecured, and though their very short-term nature makes the risk small, it is not zero. Small banks will often pay a slightly higher rate to borrow fed funds than will big banks, and an individual bank will have a maximum amount it is willing to lend to any given other bank. If a bank has a really big outflow of reserves, or its usual sources for borrowing short-term funds dry up, it may need to offer a rate well in excess of 5.25% in order to maintain a positive level of reserves.
This was the case on Friday, on which the fed funds market opened with some trades at 6%, some 75 basis points above the rate that the Fed has declared it will defend. So, the Fed used open market operations in the form of repurchase agreements to create new reserves, evidently in the amount of $38 billion. One can put this number in perspective with the following graph of what Federal Reserve deposits usually turn out to be over a two-week period. This was a huge intervention, on a par with the remarkable measures taken September 11, 2001, when the interbank loan market faced severe disruption from the physical destruction of a large number of the key institutions that make these markets. Again this week it seems that banks suddenly desired a huge volume of reserves in excess of the amounts they are required to maintain.
What exactly was the nature of the disruption this time? The problems apparently started in Europe, where Germany's IKB Deutsche Industriebank found that because of problems with its investments based on U.S. subprime mortgages, some of its usual lenders stopped extending short-term credit. In addition, France's BNP Paribas SA suspended withdrawals from three of its investment funds. Lenders of short-term funds became more cautious lending to a number of other institutions, and banks scrambling for funds bid up the overnight rate. To prevent a spike in short-term interest rates, the European Central Bank ended up injecting 94.8 billion euros, or more than 3 times the size of the U.S. intervention.
Some analysts have interpreted the Fed's action as "bailing out the banks", and are particularly troubled by the fact that the assets purchased by the Fed through the open market operations apparently involved mortgage-backed securities. I too was a little surprised that the Fed would consider buying anything other than Treasury bills, though I agree with Calculated Risk that since the reserves were injected in the form of a 3-day repurchase agreement,
unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal.
A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.
The bottom line is that the Fed was doing exactly what it needed to do. But the fact that this was needed is a very troubling development.
Posted by James Hamilton at August 10, 2007 11:14 PMdigg this | reddit
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» A liquidity event from Wcw
Weekly reserve balances with Federal Reserve banks, 1984-2007, and 8. August 2007 balance plus $38 billion This was the case on Friday, on which the fed funds market opened with some trades at 6%, some 75 basis points above the rate that the Fed has decl [Read More]
Tracked on August 11, 2007 09:00 AM
» August 13, 2007 from PrefBlog
Link heaven today, since everybody’s talking about interesting stuff! You know things are getting weird when the words “Ruble” and “Safe Haven” are mentioned in the same sentence. Things were going well until Coventree ann... [Read More]
Tracked on August 13, 2007 06:12 PM
nice explanation on the ABCs of central bank money market operations, professor. the fed has been accepting agency-backed MBS as collateral in its daily operations for several years now (along with agencies and treasuries). as you note, it is only of the high-quality type (and of which there are many more than marketable treasuries even). it is disturbing that in friday's operations all of the collateral was in the form of agency-backed MBS, certainly highlighting the serious lack of liquidity in that market. btw, the new york fed had this clarification of collateral on its web site yesterday, presumably because of the worries that people would confuse subprime with agency-backed MBS.
what is also interesting is that by the end of the day the fed funds rate had plunged to 0.5%, just as it did after Sept. 11 when it went to zero temporarily. maybe this is a (hopeful) sign that the cash squeeze is being relieved and things will turn a little more normal come monday.
Posted by: tmcgee at August 11, 2007 02:53 AM
Are the financial markets skiddish due to the Chinese saber-rattling over exchange rates with the US?
When I first heard about the Fed's action, that was the first thing that came to my mind.
Posted by: Joseph Somsel at August 11, 2007 07:47 AM
Lots of numbers.. 38 billion... 6.0% FED FUNDS but they should be put in context...
As you correctly point out...the FED FUNDS marketplace is a relatively small marketplace for unsecured loans between banks.
Over the last few years it's main function has been as a signalling process for the Fed's policy.
Its small size, however makes it difficult to use as either a Financing lever or at times an indicator.
It trades side by side with the O/N Euro marketplace and the Repo marketplace.. except that both these are many mangnitudes larger in their trading and size.
As a comparison, 38 billion dollars in Repo transactions is really a rounding error... if you like imagine that every bond future and ten year note future etc.. has underlying a repo transaction someplace to get the magnitudes straigt.
Secondly... I think its important to emphasize that FED FUNDS are not a risk free rate.. but just the rate at which two private guys wish to trade..
and there is has now become substantial and rational tiering..
There are now two FED FUNDS rates.. Good Bank and Bad.. the Bad Bank.. has to pay perhaps 20 bps's higher than the Good bank or more depending on the view...
Keep in mind that the difference between 5.25 and 5.50% over nite per million dollars is around 7 dollars per million...
These rates are averaged in just like the regular Good Bank rates.. and the FED FUNDS effective rate that one see's is an amalgam..
And there is a large option like characteristic in the FED FUNDS rate..
Banks are unwilling to trade, without knowing what the demand for funds will be later in the afternoon for their customers to whom they have guaranteed over nite liquidity...mostly commerical paper programs etc.
So when you see the FED FUNDS rate in the morning.. you don't know what the number represesnts...
A more interesting question.. is why short term rates i.e FED FUNDS...Euro's... look at the BBAM page to see what interest rates look like...
Why is the One Month rate so much higher than the Four Month rate for instance...
Why is the market driving up short rates... and buying longer ones?
Well what would you do if you were certain that the FED was going to EASE by September say??
Exactly that...since I know where there forward rates is going to be.. (assuming that the FED does ease..then i would drive up the short term rate until "forward' I create is in line with my expectations of Central Bank Policy...
Take a look at the Fed Funds futures contract.. and compare the rate on the nearby contracts with the deffered...
If you want to see the risk premium in action... look at the most liquid market of all.. the Eurodollar futures marketplace...
This is the center of all finance...period...
Three month money was set yesterday at 5.57%...
The September Euro dollarfutures.. the first contract at the IMM... settled on Friday at 94.75... which is 5.25%...
In about 1 month's Time those two numbers will have to become the same... as the Futures contract settles to the cash Fixing by contract designation..
So either 3month money will be 25 basis points lower in one maonths time... or... there will be loses of huge proportions..
Heres an interesting way of looking at that bet..
the September 94.625 put on Euros is trading at 3 ticks.. if the current 3 month rate is 5.57 when the contract expires next month.. that put will be worth 20 ticks by definiton...
Zero other wise...so...the market is paying 3 ticks to make 17 or so.. insurance premium against a credit crisis...
But...for your future work next time you write down what the expected value of a future or foward is....you might thing of this example..
Posted by: stan jonas at August 11, 2007 07:51 AM
so here's my question. The Fed is repoing, taking MBS as collateral, to provide liquidity. Taking MBS isn't all that unusual, but it's not the most typical mode of operation either. Normally a depository that wants to liquify MBS turns to its Federal Home Loan Bank for an advance. Why is the Fed doing this now, and not the FHLBs? Does some big boy who isn't in the FHLB club need liquidity, or have the FHLBs become reluctant to take even the agancy MBS?
Posted by: mort_fin at August 11, 2007 08:41 AM
Where to begin?...
Hints from China to the effect that 'we can blow the USA out of the financial water at will.'
Hints from the office of the Vice President of the United States to the effect that 'we can blow Iran off the map at will.'
And the simultaneous realization by various institutions that the fancy napkins and toilet paper in their vaults do not possess greater values simply because someone has scribbled some numbers on them. "Open the vault, take out the paper and find a sucker to buy this trash at ANY price."
This is where you arrive when you base a financial system on residential real estate lending to those who cannot repay in the absence of perpetual inflated values and refinances which allow the borowing of the subsequent year's payments. Having engineered such a structure was nothing short of an act of insanity.
The "moral hazard" finally trickled down to the level of the gardener and the counter clerk at Trader Joe's (or Whole Foods if you prefer). Yes, the borrowing frenzy even reached them. How much farther down can the moral hazard flow? Not much farther, I'll wager.
When the ultimate health of a financial system requires "making whole" the half-million dollar inflation bets of gardeners and counter clerks there is one thing that is certain ... you will not encounter a happy ending.
Posted by: esb at August 11, 2007 11:54 AM
My understanding is that the GSE have requested permission to buy more MBSs but have not yet received an answer from their regulator (per Bloomberg).
Posted by: Chrerick at August 11, 2007 04:26 PM
Cherick - not exactly. Fannie and Freddie, the two largest GSEs, need permission from their regulator, OFHEO, to expand purchases, but nothing is stopping most of the Home Loan Banks from making advances, except maybe Chicago, which is under a consent decree from their regulator, the Finance Board.
Posted by: mort_fin at August 11, 2007 05:20 PM
Bloomberg reports that OFHEO rejected this request from Fannie and Freddie.
Posted by: JDH at August 11, 2007 09:27 PM
Stan Jonas, many people share your belief that since Federal Reserve deposits are so small relative to the total Eurodollar and repo markets, it must be the latter that drive the former. Perhaps you saw my discussion last week on how these markets move together. And yet, small as it is, does it not seem to you that when the Fed announces a change in the fed funds target, the other rates all adjust? In my opinion, this is because Federal Reserve deposits, though tiny relative to world capital markets, are nonetheless uniquely important. You cannot use a Eurodollar to satisfy your reserve requirements or avoid an end-of-day overdraft on your account with the Fed. There are particular conditions for equilibrium in the market for Federal Reserve deposits, and equilibrium in every other financial market has to be consistent with that.
Posted by: JDH at August 11, 2007 10:19 PM
I saw a report a couple of days ago that futures market prices were implying that the Fed would not only lower rates by its next meeting in September, but would actually do so during the month of August, which would presumably mean making a decision at a non-scheduled meeting.
Posted by: Hal at August 12, 2007 09:27 AM
I have about 100 G in savings. should I take the money out. Should we fear a bank run at this time?
What do you guys recommend I do with my money?
Posted by: Chris at August 12, 2007 11:31 AM
Chris, presumably your account is FDIC insured (you can check with your bank), in which case I don't think you should start worrying about bank runs.
Posted by: JDH at August 12, 2007 12:33 PM
A bank that has a significant portion of its balance sheet assets in the form of MBS, and it needs cash on friday, and MBS prices are "too low", so they pledge them as collateral to get the cash from the FED. But why is their situation going to be different on Monday? Do they continue to pledge more and more MBS in return for FED liquidity until MBS market prices rise to sufficient levels? Do they keep rolling/refinancing the "repo" from the FED?
Posted by: Anonymous at August 12, 2007 04:14 PM
Thanks, this is the best brief explanation that I've seen on the Internet about the sources of recent liquidity problems.
Posted by: Mike Laird at August 12, 2007 06:28 PM
Chris, sure, if your bank fails, you'll get your $100K back. The question is when. Can you do without your $100K for weeks? Months?
Me, I purchased the Veribanc Blue Ribbon Report for California (www.veribanc.com), and intend to move my checking account from BOA to a local bank with a high equity/assets ratio and liquidity ratio.
Posted by: jg at August 12, 2007 08:32 PM
As jg says yes, you will get your $100K back but with the fed hindering business with high interest rates and now its huge injection of cash it may only be worth about $50K.
Posted by: DickF at August 13, 2007 05:53 AM
Does anyone have thoughts about the reason the European Central Bank has delivered so much more liquidity funds (over $260 billion, and counting) than either the Bank of Japan or the Federal Reserve?
Posted by: Mike Laird at August 13, 2007 02:31 PM
The Fed has been accepting agency backed MBS (thus subprime is excluded) for a while, probably started around late 1999, in preparation for y2k. As tmcgee's link no longer works directly, I am copying the clarification here:
"Typically, when the Desk arranges RPs it accepts propositions from dealers in three collateral tranches.
In the first tranche, dealers may pledge only Treasury securities.
In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities.
In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities.
From time to time, for operational simplicity, the Desk has arranged RPs just in the third tranche, under which dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities."
Posted by: pat at August 13, 2007 03:37 PM
You are right. FED guidelines prevented the FED from purchasing issues from federal agencies like Mae and Mac. In 1999 Greenspan and Co. "temporarily" suspended the clauses to allow them to deal with Y2K. Typically even though Y2K was a dud temporary became permanent. Since then the FOMC has been buying MBS. Can you say moral hazard? How about bail out?
Posted by: DickF at August 14, 2007 01:11 PM
Wow! A friend really opened my eyes. This crisis is a classic run on the bank and the FED did what it was designed to do. We all think that bank runs are a thing of the past because of FDIC and such, but all that has happened is that instruments are in different institutions now.
This is a liquidity crisis because there are no buyers and sellers.
We really need to grab some classical economics text books.
Posted by: DickF at August 15, 2007 08:32 AM
JDH, You are absolutely spot on about the pivotal role of Federal Reserve deposits in setting money market rates. One of the truisms to come from moneterism in the debates of the 60s and 70s is the inability of the private sector to manufacture suitable substitutes for the monetary base.
I am sure that there is some research out there showing that fed funds rates changes cause the corresponding changes in eurodollar rates of the same term, although there may be some autonomous changes in the risk premia on the eurodollar rates (where there is minimal regulation and no discount window).
Could Professor Hamilton provide any pointers to research in this area.
Posted by: Tim at August 17, 2007 03:46 AM
Tim, you might be interested in this paper by Young-Sook Lee, which found that the Eurodollar rate exhibits certain biweekly patterns that could only be explained by the reserve requirements for Federal Reserve deposits.
Posted by: JDH at August 18, 2007 05:48 PM