Turmoil in the repo markets allowing banks to burnish their earnings

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The turmoil that’s gripped repo markets this month, leaving hedge funds and small broker-dealers scrambling for cash, has turned into a stream of low-risk profits for some of the world’s biggest banks.

When the low-profile system for short-term secured lending sputtered for lack of funding, sending borrowing costs to the highest in a decade, banks flush with cash were slow to step forward, reined in by new rules and lacking traders with expertise.

But behind the scenes, lenders such as JPMorgan Chase & Co. have begun offering more money, lured by much higher returns than they get parking it at the central bank, according to executives in the market.

The result: Banks have offered enough to burnish their earnings. Yet it’s too little to let the market function as quietly and smoothly as it has for the much of the past decade. The dysfunction has kept the Federal Reserve pumping in money to ease the pain of hedge funds and broker-dealers that need to finance their Treasury holdings.

Large U.S. banks grew hesitant to respond to swings in repo markets for a variety of reasons including post-crisis liquidity and capital rules that constrain their flexibility to act and a reduction of desks that handle such deals.

It all came to a head suddenly in mid-September, when a confluence of factors left an unusually severe shortage of cash in a critical part of the global financial system’s plumbing. The money that big banks were willing to lend fell out of balance with the volume of securities that dealers hoped to finance -- far beyond the crunches more typically seen at the end of financial quarters. The Federal Reserve has been intervening ever since, pumping in cash to keep funding markets working.
The situation cast a spotlight on how thoroughly the environment for short-term funding has changed since the 2008 credit crisis, according to bank executives, traders and observers of the market. They said that’s even created a generational gap: Big banks and regulators have seen so little repo-market turmoil in recent years that they have lost some of their reflexes.

Volatility in the market isn’t new. It’s just that it’s been so long since it was a problem. In the 1990s, rates would sometimes spike to as high as 50% when funding was tight, according to Glenn Havlicek, a former bank executive who was in charge of JPMorgan’s liquidity management at the time. The Fed began a campaign to reduce swings in the 2000s, and then after the 2008 crisis, quantitative easing meant there was no shortage of funds. Now, after the Fed shrunk its balance sheet, the shortages are reemerging.

“There are no more fed funds desks at the big banks, and the Fed staff who used to keep the wheels of the market greased are no longer there,” said Havlicek, who now runs his own firm providing technology solutions to repo-market participants. “So when there was a funding spike, nobody remembered what to do.”

What spooked the Fed -- and led to fears that it had lost control of monetary policy -- was when the effective federal funds rate rose above the central bank’s target. Yet back before the crisis, that rate would veer from the Fed’s target quite often, whenever banks demanded significantly more or less when lending to each other. The fed funds desks Havlicek mentions were staffed to handle those transactions, creating what he estimates was a roughly $1 trillion market at its peak. Now it’s below $50 billion.

As quantitative easing flooded the system with cash after the crisis, banks parked as much as $2.7 trillion in excess reserves at the Fed. That number has since declined by half, restricting the firepower that big banks have to shift to the repo market. They have stayed active in that market for their clients, even though it typically offered only limited chances to generate significantly higher returns.

Over the past year, JPMorgan executives have said they’re being more aggressive in deploying spare cash to snap up short-term securities, rather than park it at the Fed. The firm spotted an opportunity to make more money in the repo market during last year’s fourth quarter after interest rates rose above what the Fed offers banks, former Chief Financial Officer Marianne Lake said in January. That trend continued in the first half of this year, executives said on earnings calls in April and July.

The potential to earn more at times of unusual stress is significant.

When rates recently peaked at 10%, the gap with fed funds was 8 percentage points. A bank providing $40 billion could make $8.8 million in a day. That would exceed $60 million in a week. That’s still dwarfed by the profits they generate quarterly in other businesses.

Big banks won’t start reporting quarterly results until mid-October, and in the meantime, there’s no way to estimate specific profits. But market participants point to figures that they reckon illustrate the opportunity banks enjoyed.

The first involves the bid-ask spread -- the difference between the price a buyer is willing to pay versus the lowest price a seller would accept. In short-term lending markets, the gap is typically slim. One hedge fund trader said he usually negotiates hard for banks to reduce their prices by just a few basis points. But as markets gyrated, he said, it became obvious banks were scoring fatter spreads, with some shaving initial offers by 100 basis points.

Other participants pointed to the tri-party repo market, where banks borrow from money market funds and lend to other clients. One repo trader who works in that market described the spreads he saw as the craziest he’s witnessed in three decades.

In addition to the new rules, there are long-held and newer stigmas attached to short-term funding markets. The banks generally eschew the Fed’s discount window, where they can easily borrow at 0.5 percentage points above the target rate, because it carries the stigma of having funding problems. More recently, banks have worried about the stigma of using the Fed’s overdraft facilities, where they can borrow -- or temporarily carry a negative balance -- as long as they pay it back at the end of the day. That hasn’t been used since the crisis.
“No bank will ever go negative at the Fed any more,” JPMorgan Chief Executive Officer Jamie Dimon told reporters last week. “In the old days, you would go negative during the course of the day by huge sums. So these things just change the nature of the money markets.”

Forgetting those stigmas would help alleviate troubles in markets now, some executives say. Or the Fed could stick with past practices that smoothed markets, such as the daily repo operations it resumed last week. Or if, as Chairman Jerome Powell recently stated, it plans to keep its current policy schema, it has to expand its balance sheet back to a level where there will be ample cash to never squeeze the market.

Alternatively, financial players could endure the spikes and bet that big banks and others with extra cash will be lured in to provide funding -- making profits. That would be a healthy market solution, eventually creating a system that clears faster, some executives and observers say. They argue such spikes would be temporary, and unlikely to filter into the economy by affecting wider borrowing costs for companies or consumers.

“Effectively nothing cures high prices like high prices,” said Joseph Abate, money-market strategist at Barclays Plc. “Do I think we’re going to see more volatility, yes. And the volatility will be potentially more unpredictable.”

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