Wells Fargo Advantage Money Market Funds latest "Portfolio Manager Commentary" discusses a number of major issues in the repurchase agreement, or "repo," market. Head of Money Funds David Sylvester and his team write, "Repurchase agreement (repo) rates have been excruciatingly low of late, which has depressed yields on other types of money market instruments. We've noted before the linkage between rates on repos and municipal variable-rate demand notes (VRDNs), which have become close substitutes for one another, but a similar relationship exists between repos and other instruments. If rates in one part of the market rise, investors moving from repos to that sector serve to contain that rise while, at the same time, their departure from the repo market relieves downward pressure on yields there."
The piece continues, "We've also discussed the relationship between dealer inventories of government securities and repo rates and noted that a change of $10 billion in the amount of inventory to be financed has generally led to roughly a 1-basis-point (bp; 100 bps equals 1.00%) change in repo rates. Up to this point, changes in the aggregate size of dealer holdings of government securities have resulted from fluctuations in the amount of issuance by the Treasury, or from buying and selling by the Federal Reserve (Fed) as it implements monetary policy. We are, however, beginning to see adjustments in dealer positions being driven by shifts in bank capital requirements, and these changes appear to be as significant and long-lasting as anything that's come from the Fed's quantitative easing (QE) programs."
Wells explains, "Regulations surrounding risk-weighted Tier 1 capital ratios, which require banks to hold capital in an amount calculated largely on the risk profile of the asset, have received most of the attention over the past few years. But now, in a further effort to constrain balance sheet leverage, global banking authorities have also incorporated the supplementary leverage ratio, which requires banks to hold additional capital on a non-risk-adjusted basis. Banks in the U.S. are expected to be required to comply with this additional ratio, which calls for certain levels of regulatory capital to be held as a percentage of what's called the total leverage exposure. Unlike the Tier 1 capital ratio, the total leverage exposure calculation also includes assets and other exposures that may be off the bank's balance sheet. These expected changes to the U.S. capital standards, following the proposal by international standard setters, are already having an effect on the repo market."
They add, "But for banks seeking to comply with the new ratio, there is a much easier and cheaper solution than raising scarce and expensive capital: shrink assets. And if institutions needed to shrink assets quickly and at relatively low cost, they would most likely shed the most high-quality and liquid assets on the books: U.S. Treasury securities. Now these also happen to be the ones that have the lowest risk weighting (which means they are the most levered on a risk-weighted basis), so if it strikes you as odd that banking regulation would force banks to become, on balance, more risky, you're probably not alone. But banking regulators may feel they have this base covered with the risk-weighted Tier 1 capital ratios and the supplementary capital buffers for the G-SIBs."
After discussing some additional regulatory influences, Wells writes, "This has significant implications for the repo market, which has already shrunk from $2.7 trillion at the end of 2012 to $2.5 trillion by the end of July. Because banking regulators see cheap wholesale funding as a root cause of the recent financial crisis, and the repo market is at the heart of the wholesale funding market, it's likely that shrinking the repo market is an objective of the changes in the leverage exposure calculations and not an unintended consequence. We know of several primary dealers in government securities who have cut the size of their Treasury positions by more than half, and we suspect there are others that will follow suit. This is difficult news for the taxable money market funds, which have nearly one-fifth of their assets invested in repos."
Sylvester and Co. tell us, "Most repos in money market funds mature on the following business day and thus help money market funds meet the minimum requirements for investment in daily and weekly liquid assets imposed by the 2010 amendments to Rule 2a-7. While other types of securities meet the daily and weekly liquid asset definition, they, too, are in short supply, so any contraction in the repo market definitely presents a challenge for money market fund portfolio managers."
Note: The piece contains a table of "Repos in taxable money market funds as of 7-31-13 (sourcing Crane Data) that shows Prime funds with $182 billion in repo (12% of the $1.512 trillion total), Government funds with $172 billion in repo (39% of the $441 billion) and Treasury funds with $110 billion in repo (24% of the $463 billion total). The Total in Repo holdings is $464 billion, or 19%, of the $2.416 trillion in Taxable MMFs tracked by Crane Data.
Wells also says, "But the Treasury repo market will not be the only market to contract as banks seek to shed other assets with a zero risk weighting. While the U.S. operations of foreign banks are not included at this time, the Fed has called for foreign banks to form intermediate holding companies that comply with U.S. banking regulations, so it's likely to be only a matter of time before this reaches them. In addition to managing sizable repo books, the U.S. branches of foreign banks also happen to be significant depositors of excess reserves at the Fed. Unlike U.S. banks, these foreign-bank branches are not liable for the Federal Deposit Insurance Corporation (FDIC) insurance assessment; as a result, the 25 bp interest on excess reserves (IOER) is more attractive to them on a net basis considering they've been able to borrow funds, often in the repo market at less than 10 bps, and collect 25 bp from the Fed. Now with the prospect of both sides of that trade becoming wrapped into the revised exposure measure, the foreign banks won't want to hold excess reserves any more than the U.S. banks do now. Since the total amount of reserves in the system is set by the Fed's monetary policy (and, contrary to many op-ed articles authored by people who should know better, can't be lent to borrowers) this should push the real cost of reserves down even further below the Fed's target rate."
They explain, "All of this dovetails nicely with the revelation that a staff presentation was made to the Federal Open Market Committee (FOMC) at its July 30–31 meeting regarding an expansion of the Fed's reverse repo program (RRP). From the minutes of that meeting, we learned that: "In support of the Committee's longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee's ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.""
Sylveter, et. al., explain, "A fixed-rate, full-allotment facility would imply one where the Fed sets a rate each day and approved counterparties can lend them an unlimited amount at that rate. The Fed is currently using the excess reserves from banks to finance a massive inventory of long-term Treasury and mortgage backed securities that were acquired through its QE programs. Because the Fed can't sell these securities in any meaningful size without severely depressing the market in those securities, it would be very helpful to them to obtain financing from a new source that wouldn't be subject to these more severe capital requirements. At the same time, it would be helpful to the market to find a new source of daily liquid assets from a counterparty of unquestionable creditworthiness. From money market funds facing a shortage of collateral for repos that are largely being used to meet their regulatory requirements to hold liquid assets, to the derivatives markets looking for collateral to pledge against their transactions, there is a generalized need for high-quality collateral that could be met with what the Fed holds."
Finally, the piece adds, "An RRP would also help the Fed better control short term rates now that the sea of excess reserves has all but eliminated the federal funds market. It would better enable the Fed to put a floor on money market rates once it decides to hike rates, and there is less likely to be a gap between money market yields and the Fed RRP rate. This gap between the effective federal funds rate and the FOMC's target has been a persistent problem since the Fed began paying IOER in December 2008. Originally, policymakers thought that IOER would itself provide a floor to the federal funds rates, since it seemed unlikely any bank would lend at a rate below what the Fed would pay on reserve balances in a risk-free transaction. For years, federal funds had traded near the Fed's target rate, at least until the onset of the financial crisis in the summer of 2007. But in adopting IOER, the policymakers failed to consider that the government-sponsored enterprises, who keep large balances at the Fed, were ineligible for IOER payments. Rather than leave those deposits at the Fed and collect nothing, they continued to sell into the federal funds market. Since banks were flush with deposits and excess reserves, the federal funds market lacked buyers, and the effective rate has consistently been below the target rate ever since." (Click here to read the full Wells "Portfolio Manager Commentary".)
