Can someone explain the liquidity crisis, banks & treasury bonds, and quantitative easing?

Factual Questions
1

I sort of, barely, understand right now the underlying liquidity of the banking system, the availability of cash and credit is keeping people up at night.

I’m reading about short-term, overnight bank credit being more difficult, and issues like repo loans, and memories of 2008 at one point when you there simply wasnt enough money in play, so to speak.

I’m at sea.

“Banks are holding on/have a glut of Treasury bonds”–I dont understand why this is a bad thing, and why people are dying for the Fed to buy even more (which they have been doing thus week). Is “quantitative easing” some sort of different open-the-wallet of the Fed to do so in a more formal, long-term thing?

To repeat, I just would like to know a minimum of how the financial market works.

(The current credit fears due to a collapse of the energy sector–which amounts to some 15-20% of credit the banks would have to deal with, is related, but that, at that level, I believeI have right.)

Any help?

2

My opinions on these topics may be quite wrong, but I’ll lay them out. Hopefully **Hellestal **or other experts will be along soon. Their reprimands or rebukes of my claims may make the thread more educational.

First note that federally chartered commercial banks have 1.5 trillion dollars in “excess reserves”; that amount works out to $12,000 per average household. Not exactly chump change. This is in addition to required reserves — it’s just idle cash that could be disposed of by the banks in any way, but instead is left in cash form. Or rather interest-paying cash: Am I correct that this is still paying 1.1%, arguably a gift of $16 billion annually from the FRB to the banking industry? Without this easy “free parking” income, commercial banks would have an extra $1.5 trillion they’d be trying to put to work! I hope the experts will expound on the why’s and wherefore’s but this paragraph is essentially correct.

That money has in effect been created by the Fed via its purchases of medium-term Treasury notes. In December a form of QE pushed those reserves from $1.4 to $1.5 trillion. With this hefty bankroll, it would seem trivial for the banks to maintain liquidity in the short-term “repo” market. For me, it’s somewhat mysterious that they are unable to. Is it just that they can’t be bothered, getting an easy 1.1% without working for it? Or is there some risk in the repo market, a fear that some big player will suddenly declare itself insolvent? In fact, the FRB needed to step in and purchase some $0.5 trillion of short-term paper (a large but very temporary form of QE) to keep the repo market alive. Bloomberg.Com:
Typically, such crunches present an opportunity for banks with funds to spare to lend some out, reaping a profit from the higher rates. Federal Reserve Chairman Jerome Powell in October expressed surprise that banks didn’t do more. Jamie Dimon, the head of the biggest U.S. bank, JPMorgan Chase & Co., has argued that post-crisis rules tied his hands.

OP raises two other, unrelated matters:

The 2008 liquidity crisis was caused by big financial firms no longer able to demonstrate solvency. This repo episode seems to have a wholly different nature.

Risky corporate bonds are largely laid off to institutions like insurance companies, pension funds, individual 401ks, and foreigners looking to acquire dollar-based assets. Some of these are likely to begin defaulting soon, but that’s all in a different chapter.

3

This is an enormous question.

One way to think of the economy is “money moving”.

That’s not always the best way to think of it, but it works in this case. Money moving. Private banks are part of that movement process. If private banks are buying Treasuries, they’re basically just sitting on money rather than moving it.

When the Fed buys bonds, it creates more money out of nothing to buy the bonds with.

If there is more money, it is more likely that money moves. Which is what we want right now. The direct effects of the virus can’t be avoided with more money, naturally. But if there is an indirect effect that money stops moving, well, that can be addressed.

I don’t follow this question.

The minimum point here is that demand for government bonds right now is strong because people think those Treasuries are safer than putting the money into the world by buying other things. But if the Fed replaces those bonds with more money, then money might move a little better. Can’t help direct damage from virus, but could maybe mitigate secondary indirect effects

4

Hellestal did not address the specific liquidity crisis in the “repo” market which was OP’s concern. Here’s an article about a letter that Senator Warren (D-MA) sent to Secretary Mnuchin in October.

Briefly, Dimon claims that banks’ hands are tied; that “excess” reserves aren’t excess at all but are needed to cope with onerous new liquidity rules. Critics like Warren suggest that this may be play-acting; that banks are happy ro provoke crises in hopes that the new rules will be lifted.

Again, I am no expert but some of the new rules seem diversive. For example: traditionally banks’ books are checked at the end of the business day, but new rules seem to require maintaining balances throughout daylight hours. But the 2008 crisis wasn’t caused by cash shortfalls; it was caused by huge losses on aggressive gambles.

What the banks need is more capital, so that solvency is no longer an issue. But increasing capital eats directly into shareholder profit.

5

I’ll repeat the queetion without the “opening wallet flourish: a WSJ article today quoted somebody saying he’s happy Fed is buying up Treasuries, " but it doesnt remove the excess quantity of bonds on the banks’ balance sheets which is the fundamental problem. …lFor that you a realmQE program.”

What’s the diff between what the Fed’s doing now and QE and why is “implementing” it such a big decision for the market or Fed policy? Is it rare?

6

“Repo” means repurchase agreement.

The Fed gives the banks cash. The banks give the Fed bonds. But with the agreement that the banks will “repurchase” the bonds with the cash they were given. It can be seen as a kind of loan. There’s an implication that the repurchase will eventually happen, that the whole thing is hoped to be temporary.

Some people might be looking at “quantitative easing” as an outright purchase of bonds. The Fed gives the banks cash. The banks give the Fed bonds. But no “repurchase” implied. There is no implied indefinite future date at which the banks will give the cash back, to get their bonds back.

The distinction is important to the extent that people wonder how permanent the new money is. What is important is the implied future amount of cash, regardless of how it gets injected. If the Fed uses “repo” to be seen as more temporary, then it will be less powerful. Because people will anticipate that their actions will be reversed.

7

The basic job of the Fed is to manage the amount of money in the economy. One way it does this is to set an interest rate to loan banks money. This encourages banks to lend money which creates more money in the economy. Interest rates can only go so low so the Fed can also create money directly, which is known as quantitative easing.

8

One of the most important ideas in economics, and especially in finance, is the Law of One Price.

If wheat is trading at five dollars per bushel in New York, then it shouldn’t be trading at ten per bushel in Chicago. That’s a huge opportunity to buy low and bid up the price in NY, and sell high and push down the windy city price, until the two prices match. Arbitrage. In equilibrium, the prices should be essentially the same. It’s a standard assumption of neoclassical (equilibrium-based) finance that we look at the world after equilibrium is established and the arbitrage opportunities have already been exhausted. There are no such opportunities left.

Repo transactions between private banks are collateralized lending (a little different from “repo” agreements with the central bank which can create its own cash).

It’s like a pawn shop. You want a loan, so you bring your granddad’s gold pocket watch to the shop for some cash. You must then repay the loan, with interest, or the pawn shop gets to keep the watch. In this case, the “gold watch” is government bonds. This kind of lending is safe because the lender is sitting on an asset that it gets to keep if the borrower can’t repay.

No arbitrage opportunities left: The price of wheat in NY and Chi should be near identical; repo interest rates should be roughly the same as any other lending opportunities that represent extremely little risk. Because if repo pays better than those other opportunities, then why would banks not move out of the low-interest safe assets, and into the higher-interest safe assets? It’s free money for the taking.

The Fed pays banks to hold cash and not do anything with it. (This is puzzling behavior, but they do it anyway.) This is a perfectly safe return for banks. The repo market is also extremely safe, not perfectly so, but close enough that the rate on repo should be approximately the same as the rate for excess reserves, if cash is allowed to move freely between the two places. There’s no reason to earn only the safe excess return rate from the Fed, if a bank can use that same cash and easily earn more than that with an almost equally safe asset. Repo rates should not be much higher than interest on excess reserves.

Yet we’ve also seen interbank repo rates periodically spike in the last year. As if there’s no cash left. As if all that cash in excess reserves is no longer free to move.

Because, of course, it is not. Banks were requested to use their excess reserve cash for regulatory requirements, which meant it couldn’t be arbitraged with the repo markets, and that is exactly why repo rates have been periodically spiking, and why the Fed started intervening so massively in the repo markets themselves in the last year. “Excess reserves” are no longer excess. I mean, sure, they’re still in excess of deposit regulations (hence the name), but they’re no longer in excess of capital requirements.

The Fed is intervening in repo because that’s where they weren’t getting any traction using their other policy tools.

9

The Fed does repos and QE to meet different objectives. When the Fed “injects liquidity“ they are attempting to keep the rate at which banks loan money overnight to each other low (its more complicated but im keeping it simple). Some banks keep a larger inventory of securities (say treasury bonds) than they can pay for, so they take a loan overnight from a bank with excess cash using those treasuries as collateral.

The problem is when shit hits the fan, the banks that typically loan money overnight are afraid they won’t be paid back the next day by the banks they loaned money to, and they will be left with treasuries they have to sell (potentially at a lower price). Since the risk of not being paid back goes up, so does the interest rate. This can create a death spiral - essentially a run on banks amongst professionals. As a lender of last resort, the Fed will come in loan enough money (also taking the banks bonds as collateral) to keep everyone funded at the fed funds rate. The Fed actually does this everyday to some degree to keep rates where they want them.

This action by the Fed helps keep short term rates low, but companies can’t make large investments to grow the economy with overnight loans. During the Great Depression and the Great Recession, the Fed took drastic measures to stimulate the economy. They did this by buying longer dated bonds to bring rates down for terms typically associated with long term investment. That’s QE. Unlike a repo, which is a loan, the Fed is “printing money” to outright buy the bonds. This money printing is inflationary (which was the point), but can ultimately lead to too much inflation or a lack of confidence in the US Dollar (because the Fed is just printing it whenever it needs it). The Fed said it will ultimately sell those bonds back to prevent this but no one wants to be the party pooper.

Right now the Fed is doing a few different things: It’s injecting liquidity like it normally does (but in greater amounts) via reverse repos. It’s also extending the duration of the repo loans in some cases from overnight to 1-3 months so banks don’t have to wonder every night where the money is gonna come from. Lastly, they are doing a mini-QE where they are outright buying bonds over a range of maturities. They will likely announce a more substantial and sustained QE relatively soon and will probably add corporate bonds in addition to treasuries to help the credit markets.

10

Interest on excess reserves now 0.1%. Down a full point in one go.

Just to be clear, in Fed terminology this is a repo not a reverse repo.

The Fed calls it a reverse repo when they pull cash out of the system, not put it in, presumably temporarily since the operation has an expected end date when the cash and bonds go back to their original places.

11

Remember the injection of cash in 2008-2009 was to keep the economy moving. So many banks were (possibly) exposed to bad loans (or rather, bad investments in stupid mortgage bonds) that every bank id not trust every other bank, nor did they trust any other institution that shuffled investment money. When you hand the landlord a cheque or the car dealer - they take that to their bank, and their bank will try to reconcile it to the bank the payee deals with. You use your credit card, the credit card company tries to collect from your bank when you make your payment online. Your pay is deposited into your account after being transferred from the bank which holds your employer’s account… and so on. Basically, the commerce of the nation depends on banks transferring money around every day in response to customer actions. In 2008, suddenly no bank had confidence that any other bank could actually pay what they owed for those transfers. Commerce threatened to grind to a halt. Add to that the secondary fears - if those banks go belly up, then not only do they not pay out existing transfers, but they cannot loan more money; plus, the customers work for companies that lose their line of credit and so cannot even meet bills and payroll; and if that employer is about to have a liquidity crunch and close, why would we give someone who works for them a car loan or a mortgage?

The whole banking system, the whole economy, was about to grind to a halt. The Fed had to essentially say “we will guarantee every bank’s payments” followed by schemes to make sure all banks had money to carry on normal activity like making loans and cashing cheques - and then work their way through which banks were so insolvent they needed to be would up and sold off.

But remember, in the simple normal working world, banks are required to keep a certain amount of liabilities (deposits) in cash assets - essentially, assets sufficiently reliable to deal with expected bumps in the business road, like Treasury bills. IIRC, this number was increased since the 2008 crash, because it turned out the previous number was too low. As for today… When the economy goes terribly wrong, sterner measures are called for. If a significant part of the banks’ business suddenly cannot pay their bills, either someone else (the government) has to, or the economy seizes up solid from the ripple effect of bank failures. Even worse - banks don’t even have to fail; if they suddenly find themselves holding a glut of bad debt, they cannot make more loans, no new cars or new hoses get sold, people stop buying stuff because they can’t get consumer loans, banks cancel more questionable credit cards or reduce limits to reduce the debt they are exposed to etc. Once again, the government can make those banks better by loaning them money with incredibly good repayment terms (i.e. give them money) to ensure things carry on.

12

Really? Not short-term lines of credit, but actual corporate bonds? I don’t disbelieve you, but would like to read about it.

The American people will become ill and need expensive medical services; unemployment will rise with sick leave and other compensations unavailable to many. And the Fed intends to act by pushing large sums of low-interest long-term money at corporations? Specifically the very corporations which sacrificed all prudence and gambled on buybacks, etc. to keep stock prices unsustainably high and next quarter’s profits booming?

In response to the 2008 crisis, millions of Americans lost their homes while Wall St. continued to pay out many billions in bonuses. Haven’t the American people had enough of this?

ETA: Sure, drastic measures may be needed. But this sounds like the kleptocrats are eager to exploit this “opportunity” for another huge transfer from taxpayers to the already super-rich.

13

You are correct. I’m thinking from the dealer side.

14

This is just what me and some bond trading friends (2 treasury, 2 MBS, and one credit guy) think. The Fed bought MBS in 2008 when mortgage markets were under particular duress. Most likely this will play out in corporate credit now. If they buy corporate bonds and commercial paper they can kill two birds: 1. Lower long term rates (with long duration corporates) and 2. Directly support liquidity in these markets because when companies start to go bankrupt there will likely be no bid.

As far as the kleptocratic exploitation- yes this is sort of a “trickle-down“ bailout. I’m not using that term as pejoratively as I normally would, because it is probably the smart move, and corporations and banks are rightfully one intended target. Having said that, I’d make them pay in fucking spades when things turn around. Next time they have excess cash, banks and corporations should have to bailout the federal government to help with the deficit or lighten up the Fed’s balance sheet rather than buy back their own stock. Not gonna happen without campaign finance reform though.

15

Just wanted to address this specifically.

If a slew of big, slightly over-leveraged but otherwise healthy businesses go under, the ultimate damage to everyday Americans will be catastrophic. It will fuck with jobs and supply chains to businesses with more jobs. We will also need massive fiscal policy, like direct handouts of cash to individuals, to fix the likely crisis coming. I couldn’t agree more about the lack of prudence and that, like I wrote in previous post, corporations should make good on all this when things turn around - but this bailout really does need to happen at this time.

The fact that the Fed (and the other central banks) kept interest rates so low when companies were using those loans to buy their own stock as the market doubled is completely unforgivable. The idea that anyone could think a healthy economy would be based on such low rates is laughable. If you had told me 15 years ago that rates could go negative I’d have thought you were nuts. Can you imagine loaning someone $100 for 10 years and getting 99 back? Unfortunately, no Fed Chair really wants to tighten on their watch.

16

Bond traders and I. Bond traders and I. Apparently, my grammar goes out the window with my punctuation when I slide type on an iPhone.