CEO of Wolf Street Corp. and the editor-in-chief at wolfstreet.com Wolf Richter joins Midas Letter to discuss The Federal Reserve System, market manipulation and taking price discovery out of the bond market. Wolf describes how the FED set market rates and the central banking systems motives with Quantitative Easing. Watch the entire interview for the Wolf’s expert opinion and all the implications to the broader economy from FED decision making.
James West: I’m joined now by Wolf Richter. He is the publisher of Wolfstreet.com. Wolf, welcome.
Wolf Richter: Thanks for having me.
James West: You bet. Wolf, since this is your first introduction to my audience, can you give us a quick thumbnail on how you come to know so much about the Fed and its operations?
Wolf Richter: [laughter] Well, I’m a Fed-watcher, so that is one of my little niches that I’m in, and it started in the financial crisis when the Fed started doing all sorts of shenanigans. And, you know, it is fairly transparent about some of the things that it does, so it publishes some of the data so you can actually look at it and see it. And it’s just been a fascinating experience in how it has progressed, essentially manipulating the markets and taking any kind of price discovery out of the bond market, especially.
And that has been one of its primary goals, you know. It wants to set interest rates, meaning market rates. It wants to set market rates; it can’t really set them, but it wants to manipulate the markets where they have particular rates. And it’s just a very fascinating experience to do that.
James West: Sure, you bet. You wrote an article on February 7th making the case that the Fed was winding up a sort of de facto quantitative easing operation in the guise of overnight operations in its repo market since September 2019, when there was a sudden spike in the overnight rate of interest that the repo market participants were willing to lend money at. Can you outline for my audience, please, how this repo market works, and how that operation affects, or sort of replaces, QE when they resort to printing extraordinary funds to service that interest rate?
Wolf Richter: Yeah, so let’s briefly go back a step to the four big things that the Fed does with its balance sheet; two of them were part of QE. And so it would buy treasury securities of all kinds, except treasury bills – so, those are the short-term bills. It didn’t buy any of those during QE, during the later stages of QE, but it bought the long-term securities. And then mortgage-backed securities, so, it would buy those mortgages.
During the QE unwind that started in, like, 2017, it started shedding those securities by letting them mature and roll off the balance sheet. And then we’ve got – and that worked fine until we got that stock market plunge in late 2018, and then the Fed sort of did a U-turn on these two items: on mortgage-backed securities, and treasury securities, and gradually stopped the unwind of those.
And then we’ve got, when it just had stopped them, essentially, we got the repo market blowout in September 2019. And so now, it added two more components to its toolbox, and these are now four components. And the two it added are the repos, the repurchase agreements, and buying T-bills. So, treasury bills, short term treasury bills.
And they don’t always go in the same direction. For example, it is still shedding mortgage-backed securities at a rate of about 20 billion a month, and so that’s happening; that continues to happen. The Fed wants to get rid of its mortgage-backed securities, and it’s unwinding its positions gradually, getting rid of about 240 billion, 250 billion a year. And that rate has continued.
Then, it had, in September, it started getting into repo. So these are repurchase agreements where it sells, it offers a certain amount of cash for treasury securities and mortgage backed securities to the repo market. And these are short term, so some of them are overnight repos. So these are repurchase agreement; it means I sell you something and then we agree that the next day, we reverse that transaction for a slight gain from it. And it’s like a loan, but it’s really a purchase with an agreement to repurchase the original item.
And so the overnight repos, they unwind the next day, and the Fed does them every day. And so they go to zero the next morning, and then there’s a new one coming after that, and that goes to sale the next day and then there’s a new one. And then there are so-called term repos, and the current ones are for two weeks, 14 days. The Fed does two a week, and so there’s always four of them outstanding, and they unwind in 15, usually 14 to 15 business days, and then there’ll be another one.
So, for example, this morning it did a 25 billion term repo. So this is down from the 35 billion repos it did late last year and early this year. So it is gradually reducing the amounts of these term repos, and so from 35 to 30 billion, and now we’re down to 25 billion, and pretty soon we’re going to 20 billion. And so it’s gradually taking those off the market.
There was a 50 billion 30-day repo that it did in December that carried through early January; that unwound without replacement. So when these repos unwind, the balance on the Fed’s balance sheet go to zero. Everybody takes, the Fed gets its money back and their counterparts get their securities back.
So this has had the effect that the repo balance has plunged from about 260 billion at the end of December to about 164 billion now, because it’s gradually winding down. It got rid of the 30-day repo, it’s gradually winding down the 14-day term repos, and the overnight repos have been undersubscribed all year long. So they’re now running in the range of 30 to 50 billion a day, and they unwind the next day and then there will be another one.
So this entire repo episode is winding down, and the Fed is now discussing a prominent repo facility which would be there if these repo rates spike. And so there wouldn’t be any big to-do about it; the Fed could just step in. It used to have a standing repo facility before the financial crisis, and it used it constantly, so there was constant repo activity. During the financial crisis, the Fed started buying all the securities, so it ended the repo program; now, it’s thinking about reinstating a permanent repo facility that will interfere in the market on a fairly small scale when needed.
So the repo thing is now winding down. The keep it all thing is doing the opposite. So the Fed has decided that one way to solve the repo blowout is to add liquidity to the system via short-term treasury securities, so the Fed is buying those short term treasury securities at a rate of about 60 billion a month. That means that it’s adding to its stash at a rate of 50 billion a month. They mature constantly; they’re 30 days and 90-day securities, so they’re now maturing, and when they mature, the Fed replaces those, and in addition, it adds about 60 billion a month.
So we’ve got both those three different directions going. Mortgage-backed securities are declining at a rate of 20 billion a month; the T-bills are increasing at a rate of 60 billion a month; and the repos are now declining at a somewhat uneven rate, but they’ve come down quite a bit. So the net effect has been that in terms of the Fed’s overall assets, they really have not moved since the end of December. They kind of wobble up and down a little bit, but they have been essentially flat.
So that huge pileup of assets that it did, that $410 billion that it added from the mid of September through the end of December, that has, you know, those assets are still there, but they’re not increasing anymore. So the QE part of it is essentially gone. It’s just maintaining its levels right now by increasing on one side and decreasing on the other side.
James West: Hmm. Interesting. So with the permanent facility in the repo market, I guess that is in part designed to prevent any sort of spike in rates, which occur when the participants in the repo market say, Hey, we’re not going to give you our treasuries; we want to hold them, because we’re not satisfied that that interest rate at 1.8, 1.6, delivers enough of a offset to the risk associated with an overnight operation? Or, what is it that causes the overnight rate to spike? And I’m pretty sure you’re going to tell me it’s because the participants withhold, you know, participation, based on an effort to drive a higher rate into the market. Is that correct?
Wolf Richter: Yeah, so, we don’t really know yet, because the Fed has not disclosed exactly what’s causing it. The Fed has said it’s studying the causes. Some things have emerged, though: so we know that the big banks, including JP Morgan, refused to lend to the repo market. So they refused to supply the liquidity starting in September, and this happened at the end of 2018, as well, but it was short-lived and in September it was not as short-lived.
And so we have, we know that. So we know that there was a shortage of supply and liquidity from the banks that would normally be happy to supply. So, you know, when the rates spike to 3 and 4 percent and the banks can borrow at 2 percent, you know, it would be very profitable for the banks to lend to the repo market. And the rates spiked to 10 percent, you know, so it would have been hugely profitable for the banks to do this, but for various reasons – and that’s not being looked at; some of them are regulatory reasons, other are, you know, people saying that maybe the big banks got together and tried to force the Fed’s hand on this, to loosen up regulations – so there’s all kinds of theories floating around.
The Fed has simply said it’s going to wait a couple of years before it discloses what it finds. So we don’t really know, but we know that on the other side – so these are repurchase agreements, so there’s another side to it, and the other side is entities that fund their own investments in the repo market. So, they’re borrowing in the repo market, and these institutions include, obviously, banks, but also hedge funds and mortgage, real investment trusts. And we don’t know anything about hedge funds, but we do know something about these mortgage real estate investment trusts, because they’re publicly traded.
And so we can go to the SEC and we can look up in their filings what they’re doing, and I did that, looked at one of them, and they, all they do is, they make money off the difference between mortgage-backed securities, which is what the earned money, and the cost of the funds when they borrow in the repo market is very low. So they have a pretty good spread there, and that’s all they do: they leverage that spread.
And so they make long-term investments. They buy mortgage-backed securities, which are long term investments, and they fund them short term in the overnight repo market and perhaps with two REIT money and some with a little longer in the repo market. So they’re forced borrowers. They have to borrow.
So when the repo market dries up, when it locks up, when the rates spike, they have trouble borrowing, and they can no longer fund the mortgages, and they would have to default on some of their obligations. And the one I looked at had $110 billion in mortgages sitting on its balance sheet, and that’s a pretty good chunk, and if that start – and there’s a bunch of others like this, you know. It’s not the only one, it’s just the one I happened to look at.
And so you’re talking maybe $1 trillion in mortgage backed securities that are sitting in these funds that could possibly, where these funds could possibly blow up. The mortgage-backed securities are good, but the funds that are folding them, they have to fund them in the repo market, and when the repo market doesn’t supply the funds, this whole scheme falls apart. And I think the Fed saw this, and the risk is that contagion spreads from these hedge funds and these mortgage REITs and that it will impact the overall financial system, given how big the numbers are.
And so the Fed sort of panicked and jumped in, trying to solve this, and I think it was this combination of the banks not stepping up to the pump because of various reasons, and then the forced borrowing that’s going on in the repo market on the other side. Now, these are organizations, these financial institutions, they’re borrowing in the repo market. They can’t just borrow somewhere else overnight. This is something that’s in their system; it would take a long time for them to find other sources of money.
So they’re really dependent on the repo market, and they disclose that in the financial statements. They say that’s one of the risk factors, you know? If we can’t borrow in the repo market, we may go out of business. We may blow up. They say this. And so this is, I think this is the other side of the problem, where these big funds could no longer fund their long-term investments with overnight repos, and you know, it got to be very risky.
And I think the bigger issue is with these institutions and how far they have come to rely on the repo market. It’s very risky to invest long-term and fund those investments in short term markets. I mean, banks do that all the time, but banks are FDIC insured and heavily regulated. These funds are not regulated, and when they do it, it gets very risky.
James West: Mm-hmm. So then, what is the implication for the – like, what’s the risk to the broader economy and the market, generally?
Wolf Richter: Well, when the financial system blows up, as we have seen – I call this the coronavirus in finance, you know; things come to a halt. So that’s not a good situation. If it’s just limited to the repo market, I would have liked to see that, actually. I would have liked to see there be some damage on the borrowers’ side in repo markets so that they pull back a little bit. The repo market, it has $4 trillion in transactions every day; it’s huge. There’s a lot of people involved in this, and Fed is just a small player in it.
And so there’s a lot of companies that rely on this short-term funding to finance long term projects, and it’s very risky, and it would have been nice to see several companies blow up in this so that some of the risk gets taken off the table. And that’s the thing that the Fed tries to prevent all the time; it’s more hazard. It’s trying to avoid that anybody’s learning any lessons in this.
And so it bailed the repo market out, and now the lesson is that the Fed will always bail out the repo market, and there’s no risk involved in borrowing in the repo market. So if it’s just limited to the repo market, I don’t think the real economy will suffer, and I would have liked to see that. If the contagion spreads throughout the financial system and starts blowing up some of the big banks, which I doubt, but it could, I think this will be a huge issue.
James West: Wow. Wolf, I could probably talk to you for hours and hours on end. Unfortunately, we’ve run out of time today. I will come back to you, and I really appreciate your time today. Thanks for joining me.
Wolf Richter: Thank you, James.