| NEW YORK
NEW YORK Nov 6 The Federal Reserve's efforts to
lower U.S. interest rates and increase borrowing to stimulate
the economy may be running into a problem of the Fed's own
making: the stubbornly high cost to borrow short-term funds is
constraining the ability of banks to make cheap loans.
The Fed has been selling short-dated Treasuries in order to
finance its purchases of longer-dated government bonds. It hopes
this will reduce longer-term interest rates and boost borrowing
needed to raise spending and reduce the jobless rate.
The sales have pushed up the cost to borrow in the vital $5
trillion repurchase agreement (repo), even though other
borrowing rates have declined, as banks struggle under the
weight of absorbing the short-term debt.
This is making it more costly for banks to fund new consumer
and corporate loans, and for companies such as REITs to finance
purchases of mortgage-backed debt that help borrowers buy homes.
If high repo rates persist, the Fed may choose to intervene
in the market to try to bring them down, a move that could prove
politically unpopular, analysts said.
"If the Fed's intention is to provide unlimited liquidity
and ensure a cheap cost of credit, elevated repo rates run
counter to this goal," said Boris Rjavinski, an interest rate
strategist at UBS in Stamford, Connecticut.
The cost to borrow overnight in repo has increased to around
23 basis points, from around 10 basis points at the beginning of
the year. At the same time, the three-month unsecured London
interbank offered rate (Libor) has declined to 31 basis points,
from 58 basis points.
The higher rates offered by repo loans are also luring
investors such as money funds, at the expense of other loans
directed at companies or consumers.
"The Fed would much rather see money market funds sponsor
direct forces of credit creation to consumers and companies, but
as long as repo is an attractive alternative, its going to
siphon some of the money market funds lending capacity away from
other loans," said Rjavinski.
Money funds increased their repo lending to record levels in
July and August, where the loans topped 25 percent of the total
assets of taxable money funds for the first time, according to
data firm Crane Data.
At the same time as the repo loans increased, loans made to
government agencies that guarantee mortgages and to companies
through commercial paper declined, Crane data show.
Repo loans fell in September due to quarterly
"window-dressing", but "October data will no doubt show a
rebound," said Peter Crane, President at the firm.
High repo rates also hurt Real Estate Investment Trusts
(REITs), which use repo funding to purchase mortgage-backed
securities, and profit from the difference between the two
REITs typically borrow at leverage of 6 or more times, which
further magnifies the spread compression as repo rates rise and
as mortgage-backed debt yields are held down by Fed purchases.
Recently, "REITs are not reported to have been as active in
buying MBS, and part of the reason could be elevated funding
costs," said Walter Schmidt, head of mortgage strategy at FTN
Financial in Chicago.
For large banks, the high repo rate is further constraining
their capacity to lend at the same time as new regulations and
higher capital requirements shrink their balance sheets.
It is further reducing profits to their large fixed income
operations, which are already suffering from the low yielding
environment and reduced trading activity.
"Repo affects liquidity a little bit among dealers," said
Some analysts expect the high repo rate should ease by next
year as the Fed's sales of short-dated debt in its Operation
Twist program are due to expire at the end of this year.
Should the high rate continue, the Fed may be forced to
intervene, a strategy that could require it to further expand
its balance sheet.
This might prove unpopular as many oppose the Fed's money
printing, which has weighed on the dollar. There are also
concerns more easing will make an exit from the Fed's ultra
loose monetary policy more difficult when the economy improves.
The Fed could lower the rate in a reverse repo operation, in
which the Fed would lend funds to banks, in return for
Treasuries the banks post to back the loans.
"We think that the Fed may address repo rates in its next
easing effort," said UBS' Rjavinski.
Another option may be for the Fed to undertake more roll
financing in the MBS market, said FTN's Schmidt.
In these transactions, the Fed can sell MBS for one month,
then by it back at a later date for a lower price, a strategy
that has the effect of lowering the financing cost.
A lower cost of roll financing would then have the effect of
bringing down repo rates, because of the arbitrage opportunity
between the two rates, Schmidt said.
"Once we get past the election they might choose to be more
active in the roll markets, that would help roll financing for
money managers and it would help repo financing," he said.