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Saturday, August 11, 2007

Jim Hamilton: What is a Liquidity Event?

Jim Hamilton takes a look at recent "troubling" events in financial markets:

What is a liquidity event?, by Jim Hamilton: It was an exciting week in financial markets, including some dramatic central bank interventions in short-term money markets. ...

First, a little background... The banking system as a whole usually holds only a small amount of reserves in excess of what is required. A bank that ends up with extra reserves would find it advantageous to loan Federal Reserve deposits overnight to a bank with a deficit in what is called the federal funds market. The interest rate on these overnight loans is usually very sensitive to the quantity of excess reserves in the system, so the Fed could change this rate by adding or subtracting deposits through open market operations. The Fed simply announces the rate it intends to maintain, with the current target being 5.25%, and the announcement is credible because all participants know that the Fed will be adding or draining reserves as necessary to keep the rate near the target.

Not all loans will take place exactly at the target rate, however. These loans are unsecured, and though their very short-term nature makes the risk small, it is not zero. Small banks will often pay a slightly higher rate to borrow fed funds than will big banks, and an individual bank will have a maximum amount it is willing to lend to any given other bank. If a bank has a really big outflow of reserves, or its usual sources for borrowing short-term funds dry up, it may need to offer a rate well in excess of 5.25% in order to maintain a positive level of reserves.

This was the case on Friday, on which the fed funds market opened with some trades at 6%, some 75 basis points above the rate that the Fed has declared it will defend. So, the Fed used open market operations in the form of repurchase agreements to create new reserves, evidently in the amount of $38 billion. One can put this number in perspective with the following graph of what Federal Reserve deposits usually turn out to be over a two-week period. This was a huge intervention, on a par with the remarkable measures taken September 11, 2001, when the interbank loan market faced severe disruption from the physical destruction of a large number of the key institutions that make these markets. Again this week it seems that banks suddenly desired a huge volume of reserves in excess of the amounts they are required to maintain.

Hamilton81107
Federal Reserve deposits (in billions of dollars) and size of this week's reported liquidity injection. Original weekly data have been converted to biweekly. Data source: FRED

...Some analysts have interpreted the Fed's action as "bailing out the banks", and are particularly troubled by the fact that the assets purchased by the Fed through the open market operations apparently involved mortgage-backed securities. I too was a little surprised that the Fed would consider buying anything other than Treasury bills, though I agree with Calculated Risk that since the reserves were injected in the form of a 3-day repurchase agreement,

unless the banks go under in 3 calendar days, they will pay the loan back with 3 days of 5.25% interest. No big deal.

More sound analysis was provided by Felix Salmon, King Banian, Paul Krugman, and Mark Thoma. And here's William Polley:

A lot of entities holding mortgage backed securities needed liquidity. They were willing to borrow at a higher overnight rate to get that liquidity as evidenced by the spike in the funds rate early in the morning. The Fed, quite understandably, did not want the funds rate to spike, and so they loaned these banks reserves accepting mortgage backed securities of the highest quality as collateral (the Fed was NOT bailing them out by buying distressed subprime loans). This kept anyone from unloading good quality assets at fire sale prices just to get liquidity. That would have been disastrous. The agreement is that on Monday the banks get their securities back and the Fed takes back the reserves.

The bottom line is that the Fed was doing exactly what it needed to do. But the fact that this was needed is a very troubling development.

    Posted by on Saturday, August 11, 2007 at 12:33 AM in Economics, Monetary Policy | Permalink  TrackBack (1)  Comments (19)

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