Tuesday, April 5, 2011

New Fee Shakes Up a Lending Market

New Fee Shakes Up a Lending Market


The money market has been roiled by a sudden shortage of Treasury securities, another unintended consequence of government involvement in financial markets.

The disappearance of Treasurys in recent days has created a scramble among banks and investors, who depend on a fluid supply for short-term borrowing and lending. It is an unusual event, considering the market is generally awash in Treasurys, with about $9 trillion outstanding.

But recent rule changes mandated by the Dodd-Frank laws have made it too expensive for some banks to offer out their Treasurys holdings as part of a key overnight lending market known as the repurchase or "repo" market.

Banks typically borrow in this market, using Treasurys as collateral, parking the cash with the Federal Reserve and earning a better interest rate. Investors and money market funds use the market to lend out their cash overnight and earn a small return.

The lack of supply was so severe on Monday, and some investors so desperate for Treasurys, that they accepted negative yields—effectively paying to lend money to the banks. That is something that has rarely been seen since the financial crisis.

Exacerbating the problem, the Treasury has stopped selling some short-term Treasurys amid the debate in Washington over the government debt ceiling. At the same time, the Federal Reserve is suctioning up most of the new Treasurys that the government is selling, adding to the shortage of Treasury supply.

"It is a perfect storm of collateral being pulled from the market when it is most needed," said Thomas Roth, executive director in the U.S. government bond-trading group at Mitsubishi UFJ Securities (USA) Inc. in New York.

Joseph Abate, money-market strategist at Barclays Capital, noted that about $40 billion in repo collateral abruptly disappeared on Friday, in what traders said was one or more big banks exiting the market.

Banks have pulled back on their repo activity since the Federal Deposit Insurance Corp. imposed an added charge on bank repos as of April 1.

The new assessment was designed to better reflect the risks on individual banks' balance sheets by charging them for liabilities, including repo-market activities, instead of just their deposits.

An FDIC spokesman declined to comment on the market impact.

The average interest rate investors receive for lending Treasury debt in that market have fallen to nearly zero from about 0.15% since the end of March, according to Scott Skyrm, head of repo trading at Newedge USA in New York.

Rates have been ratcheting lower for some time, making the money market "an ever-worsening house of pain," Anthony Crescenzi, portfolio manager at Pacific Investment Management Co., or Pimco, wrote in an email.

So far, the tensions in the markets have been mild compared with the 2008 financial crisis, when the money market essentially seized up.

Still, the decline of repo rates, if it lasts very long, could be bad news for money-market funds that make money by lending Treasurys to banks and other investors.

There is an outside chance that long-term disruption of the repo market, a key source of funding for many corners of the economy, could eventually lead to higher borrowing costs more broadly.

Most think the turmoil will be temporary, and the Fed would likely intervene before too much damage was done.

"I think the market has overreacted here a bit and will probably go back to its equilibrium level," Mr. Abate said. "I'm just not sure how quickly."

It is possible that the market could be in some upheaval at least until the resolution of the debate in Congress over the U.S. government's debt ceiling.

That is because a shortage of available Treasurys for use as repo collateral seems to be a major factor driving repo rates lower.

That Treasury shortage, in turn, is partly due to some short-term Treasury debt issuance being on hold until the debt-ceiling issue is settled.

For now, the government is probably not complaining about the shortage of Treasurys, which is driving its borrowing costs lower for now. Prices on Treasury debt have risen sharply since Friday, driving yields—which move in the opposite direction—lower.

The six-month Treasury bill's yield fell to a low of 0.122%, a record, on Monday.

Late afternoon, the benchmark 10-year note was 5/32 higher to yield 3.429%. The two-year note rose 2/32 to yield 0.774%.

At the same time, the repo market is flooded with cash being pumped by the Fed in an effort to goose the economic recovery. One possible solution for the current turmoil is for the Fed to stop buying, and even start lending out, some of its Treasurys.

But that would send mixed signals to the market while the Fed is still in the middle of its $600 billion Treasury buying program.

The Fed would likely rather deal with some short-term turmoil in the repo market than work against its own liquidity measures. And part of the Fed's intention with its liquidity pumping programs has been to make it more painful for investors to stay in cash, forcing them to buy riskier assets.

Write to Mark Gongloff at mark.gongloff@wsj.com and Min Zeng at min.zeng@dowjones.com

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