Fed's default crisis tools back on the shelf - for now

NEW YORK Thu Oct 17, 2013 4:19pm EDT

NEW YORK (Reuters) - Federal Reserve officials sighed in relief on Thursday after the U.S. government avoided a potentially devastating default, relieving the central bank of the need to take yet more extraordinary measures to stabilize the financial system.

But with Washington's borrowing authority only raised temporarily, the Fed may still be called on in the months ahead to deploy a largely experimental arsenal should another round of political dysfunction result in an actual default.

The Fed's playbook for coping with traumatized financial markets should the federal government fail to make an interest or principal payment on the U.S. debt is largely untested. Much of it is based on contingency plans drawn up in 2011, when the government came within days of hitting its legal borrowing limit and defaulting on its debt.

The latest political standoff in Washington, which ended late Wednesday with a deal to extend the country's borrowing capacity for almost four months, had Fed officials refining and testing those plans, in consultation with Wall Street.

Richard Fisher, president of the Federal Reserve Bank of Dallas, hinted the central bank learned a valuable lesson in the default scare of 2011.

"I'm more confident that we, my colleagues and I, are better prepared for this than we were in 2011," Fisher told Reuters this week. He said the Fed would do all it could "to prevent market chaos.

Fisher and other Fed officials would not elaborate, however, leaving investors to guess at details of what exactly they would be willing and able to do in the face of a default. Officials have been careful not to overstate how effectively the Fed could mitigate any fallout given the unpredictable market reaction.

In times of financial crisis, the Fed acts as the lender of last resort to the nation's banks, but it requires them to pledge collateral for the short-term loans they use to keep their businesses running. A key problem is that as often as not that collateral is U.S. Treasury bills, notes and bonds, which would be expected to lose value in the event of a U.S. default.

Treasuries are also the common collateral pledged in short-term funding transactions between banks and other private parties.

In the days before the crisis was averted, banks held the expectation that the Federal Reserve Bank of New York, which acts as the Fed's agent in financial markets, would accept defaulted Treasuries from banks in exchange for securities that have longer-term maturities, a senior executive at a major Wall Street firm said.

The Fed could also ramp up so-called reverse repurchase agreements, or repos, which would provide dealers sound collateral from its vast inventory in a short-term pinch. In fact, the Fed had been running operational tests on that facility since late last month, a tool it also expects to use to manage short-term interest rates down the road when it finally moves away from the era of rock-bottom rates.

The repo and other short-term lending markets could jam up if the U.S. Treasury is late in making its payments, possibly sowing confusion and hampering lending. Beyond that, such a historic default could undercut economic growth in the United States and around the world.

Legal guidelines appear to suggest the Fed can accept as collateral defaulted Treasury bonds, as long as they are not "subject to any regulatory or other constraints that impair their liquidation."

Investors this week were discussing the possibility that the Fed could accept such debt as collateral. In a client note, fixed-income analysts at JPMorgan said they believe the Fed would do so, "but we do not know for certain."

Still, they said, it would "appear very inconsistent for the Fed to continue to purchase Treasuries in open market operations - or hold over $2 trillion of them, for that matter - and not accept Treasuries as collateral at the discount window in the event of a technical default."

The Fed holds some $3.7 trillion in bonds after years of asset purchases meant to hold down long-term interest rates and boost U.S. economic growth. Its current bond-buying program is worth $85 billion per month, including $45 billion in Treasuries.

Critics, including a number of congressional Republicans, have charged that the Fed's aggressive stimulus has tacitly allowed the government to avoid setting a budget that reduces the country's debt load. Any moves by the Fed to soothe a possible default could bolster such criticism.

Fisher, in the interview this week, warned there is a tipping point at which the central bank will "come to be viewed as an accomplice" to lawmakers' "reckless" actions, though he said the contingency plans at banks are also better following the 2011 default scare.

Banks have bulked up on Treasuries and other safe-haven securities in response to the 2007-2009 financial crisis and tougher capital rules, as well as in response to the two recent default scares, which could reduce chaos if it actually occurs.

"We had a pretty good scare in the summer of 2011 so we were more prepared in that way," said Bret Barker, portfolio manager with TCW in Los Angeles. "The Fed has so much more liquidity in place."

(Additional reporting by Richard Leong and Karen Brettell in New York; Editing by Dan Burns and Leslie Adler)

Recommended Newsletters

Reuters U.S. Top News
A quick-fix on the day's news published with Reuters videos and award-winning news photography and delivered at your choice of one of four times during the day.
Reuters Deals Today
The latest Reuters articles on M&A, IPOs, private equity, hedge funds and regulatory updates delivered to your inbox each day.
Reuters Technology Report
Your daily briefing on the latest tech developments from around the world from Reuters expert tech correspondents.