The Federal Reserve has taken an unusual step this week. To my knowledge the action is without precedent. There was no prior announcement or discussion preceding the new measures. By itself, this is atypical for Bernanke’s Fed. Ben doesn’t like to surprise markets. He did this time (I’m sure he personally approved the move). Some details and thoughts on what it might mean.
For years the NY Fed has conducted “Dollar Rolls” of MBS securities with the Primary Dealers. These transactions provide liquidity to the MBS market. The Fed’s description:
The Federal Reserve uses agency MBS dollar rolls as a supplemental tool to address temporary imbalances in market supply and demand. A dollar roll is a transaction conducted at market prices that generally involves the purchase or sale of agency MBS for delivery in the current month, with the simultaneous agreement to resell or repurchase substantially similar (although not necessarily the same) securities on a specified future date.
Still confused? So am I. My conclusion is that this is benign. The Fed is just providing order and a degree of predictability to an important capital market. I also don’t know how much of this is going on. This Reuters article suggests that it is a Trillion dollar market. (Would love some help on the #s?)
Why would the Fed establish a new margin requirement on something that has been going on fine without one for years? Why now? The answer is easy. It’s the fallout from MFG.
In a dollar roll the Fed has no principal risk with the counter-party. The cash and securities are settled through a clearinghouse. But they do have risk in the event the counter-party fails during the 30-day roll. If that were to happen, the Fed would have to replace the position with another party and in the process could suffer a loss.
In an effort to avoid this loss the Fed has established a new 2.5% margin on all MBS dollar rolls. From the Journal:
The Federal Reserve said it will be increasing collateral requirements on 21 primary-dealer banks in transactions dealing with mortgage-backed securities, in a move that would be aimed at securing an extra layer of protection against settlement risks with its counter parties.
* What kind of message does this send? (It was communicated to the PDs via a conference call!) It sends a very mixed message in my direction. Essentially the Fed is saying, “We’re not so sure we can trust all of you”. Of course this position is justified given that MFG (an ex PD) went into the tank in a matter of days.
It would have been nice if the Fed had taken a different approach and said:
We’ve looked very close. MFG was the only bad apple. It won’t happen again. We’re comfortable with our counter party risk. No need for changes in margins or haircuts.
But they didn’t say that. In fact they have said/done quite the opposite. So to me, it sends an ominous message.
* A shot at the numbers. Say it was a trillion dollar market. That would mean that at any point and time there would be about $80b outstanding. 2.5% of 80 large comes to a neat $2b. That’s not so much money for the PDs. But this is equity money. There is a cost to equity these days at the big firms. There is not one of them that has excess tier 1.
* I have heard that all the PDs are bellyaching big time over this. It will eat into their profits. I also heard that some of the European banks that are also PDs (BNP, Barclays, Credit Swiss, Deutche Bank, UBS) are really pissed. This is not a good time for them to be asking the Head Offices for an additional allocation of capital.
* I don’t think this is all that profitable of a business for the PDs. It’s just part of the grind of financing Agency MBS paper. This is a slap in the face of the PDs.
*This appears to be very bad timing by the Fed. We shall see if anyone (other than me) interprets the new margin requirements as a warning sign. I believe we are on very shaky ground on the matter of sovereign debt and the brokers who make the system work. We can’t afford to let a few more straws fall on the wobbly camel. I think the Fed may have just added to the fray of concerns.
*I’m making a big deal of this. I think it may prove to be important. Anytime that the Fed does something unanticipated it’s worth noting. There is always something more than meets the eye. The timing is odd. The optics are terrible. The Fed is making credit harder to get (very big numbers involved in MBS land) at what may prove to be exactly the worst moment.
Ben Bernanke has often spoken on the history of the depression. He has pointed at the errors of the FRB in 1937 when credit was tightened and a second leg of deflation started. He has said he would not make that same mistake again. I wonder if he just did. Sometimes small things bring big results in our complex markets.