Old decision on GSEs may hamper Fed's rate-hike effort

NEW YORK, Dec 15 (Reuters) - The Federal Reserve’s decision a decade ago to curb borrowing by federal mortgage agencies may end up haunting the U.S. central bank in its attempt to drain cash from the banking system following its widely expected interest-rate hike this week.

In July 2006, the Fed ended a policy allowing it to give interest-free daily loans, known as daylight overdrafts, to the likes of Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

But by cutting off this line of credit, it seems to have held back these agencies’ participation in a Fed policy program seen as vital for the U.S. central bank to successfully move away from its near-zero interest rate policy.

That is the Fed’s reverse repurchase program, which is intended to siphon cash from money market mutual funds and mortgage finance agencies who are major lenders in short-term rates markets.

If the GSEs do not shift more funds out of the short-term money markets and into the Fed’s reverse repurchase program, some traders and analysts worry the Fed will struggle to keep short-term rates above the low end of its intended range.

“Given how much they are part of the fed funds market, they are going to be pretty critical in helping the Fed,” said Gennadiy Goldberg, interest rates strategist at TD Securities in New York.

The Fed’s decision was intended to curb excessive borrowing by these finance agencies.

The GSEs must have enough cash on hand at the beginning of each day to cover daily payments on loans and securities. The GSEs, deprived of daylight overdrafts, prefer to make overnight loans in the fed funds market where they are repaid at the start of each day, rather than the larger repurchase agreement market where they would be paid back in the late afternoon, analysts said.

“Since they can’t run an overdraft in their account at the Federal Reserve, they prefer non-triparty repo trades - like fed funds - where they can be assured of receiving their unwinding cash early in the following day,” according to Barclays’ money market strategist Joe Abate.

This is a key factor why analysts say GSEs have not fully embraced reverse repurchase programs. Since the financial crisis, there has been a jump in their share of lending in the federal funds market, whose interest rates the Fed seeks to control to achieve its policy objectives.

This means the Fed has a tough task to direct some of over $200 billion in cash and cash equivalents the GSEs have to the RRPs, since the program does not seem to appeal to this key group of lenders.

It is unclear whether the GSEs will raise their participation with enticement from higher RRP rates, analysts said.


FHLBs, which finances banks, credit unions and other members that make mortgages, are the single biggest lender in the fed funds market, Abate said. In a fed funds market worth $40 billion to $50 billion, the FHLBs account for up 90 percent of the daily trading volume, Abate said.

“They are the biggest players in the fed funds market right now. Their participation has a huge influence on the fed funds rate,” said Tom Simons, money market strategist at Jefferies & Co. in New York.

Fannie, Freddie and 10 regional FHLBs qualify for the Fed’s reverse repo program where it pays participants interest to hold its Treasuries.

But the GSEs have been relatively small users of RRPs since the Fed began testing it in 2013, compared with money market funds. In the second quarter, the Fed on average awarded government-sponsored enterprises $10.5 billion in RRPs daily, compared with $90.1 billion for money market funds, according to the latest Fed data.

Some analysts forecast the Fed will raise the cap on its RRP program from the current $300 billion. Bank of America Merrill Lynch analysts said on Tuesday the RRP ceiling could go up to $500 billion to $800 billion.

“The FHLBanks help provide stability and reliable liquidity to the U.S. financial system. We intend to work cooperatively and constructively alongside the Federal Reserve to serve our respective purposes,” said David Jeffers, executive vice president of policy and public affairs with the Council of FHLBanks, in an email statement.

Freddie did not respond to requests for comments.

At end of the third-quarter, the Federal Home Loan Bank System lent $31 billion in fed funds. Fannie and Freddie had $26 billion and $53 billion in both fed funds and repurchase agreements, respectively.

Of the three, Fannie is the heaviest user of the Fed’s reverse repo program, Abate said.

“Fannie Mae is an approved counterparty for the Fed’s reverse repo program. The company does not disclose program business activities,” Fannie Mae spokesman Pete Bakel said.

Reporting by Richard Leong; Editing by Chizu Nomiyama