Fed Considers Reverse Repo with Money Market Funds

Your 401K and IRA may get stuffed with bonds no one wants.

Last week the Financial Times reported that the Federal Reserve was considering the use of reverse repurchase agreements (aka 'repos') as a way to reduce its balance sheet ("Fed turns to mutual funds to stave off inflation", 9/24/09 Financial Times). The twist is two-fold: that the Fed wants to do it with large money market funds and not with Primary Dealers, and that the Fed wants to do it with agency bonds and agency-backed MBS, and not Treasuries as they normally do.

The Federal Reserve has used 'repos' with Primary Dealers, and never with any other financial entity. I simply do not know if their charter allows them to deal with money market funds. The reason for the Fed's wanting to deal with money market funds is their sheer size: $2.5 trillion. According to the FT article, the Fed thinks Primary Dealers do not have big enough balance sheets to absorb the Fed's collateral (agency, MBS). By the Fed's estimate, Primary Dealers would have $100 billion that they can spare to accommodate the Fed.

Thus the Fed targets the $2.5 trillion money market funds, where the investors very large and miniscule alike park their unused funds, in 401K, in IRA. And the Federal Reserve wants to stuff them with securities that hardly anyone in the world wants to hold at this point.

Repos and reverse repos are used by the Federal Reserve to temporarily increase (repo) or decrease (reverse repo) the bank reserves. In repos, the Fed temporarily buys Treasury securities from Primary Dealers, thus adding to the bank reserves. In reverse repos, the Fed temporarily sells Treasury securities to Primary Dealers, draining the bank reserves. Repo and reverse repo agreements are usually overnight; though it can be as long as 65 business days it is rarely longer than 14 days (in other words, not very long). [information from Federal Reserve Bank of New York]

Now, if the Fed wants to do reverse repos with money market funds by selling them agency bonds and agency-backed MBS, my questions are:

At what price?
Currently the Fed carries these bonds at FACE VALUE on their balance sheet. Many believe agency bonds and agency-backed MBS trades well below their face values. I don't see why the Fed, in reverse repo, would mark them to market. So the Fed would sell these bonds that hardly anyone in the world wants at this point to money market funds at face value. A dollar for a dollar.

How to account?
Since money market funds are not Primary Dealers, they are not banks and they are not even the Federal Reserve members, where would the reverse repos be accounted for on the Fed's balance sheet?

The Fed sells agency bonds/MBS, which decreases their asset balance temporarily. It receives money for the sale, which then increases the asset balance. So on the asset side of the balance sheet it is basically a wash.

On the liability side, the Fed records 'reverse repo', thus increasing the liability. Since the asset side is a wash, the liability side has to be a wash, too. But since the money market funds are not Primary Dealers and not even the Fed member banks, the Fed cannot reduce the bank reserves as they normally do with regular 'reverse repos' using Treasury securities. So they will have to create a new line item on the liability side of the balance sheet that would offset the 'reverse repo' amount, or create a new line item on the asset side that would somehow account for the reverse repo not being offset on the liability side. How they do it I haven't a clue. But the book has to balance somehow.

Is the Fed allowed to do this?
Money market funds are not Primary Dealers, they are not banks, and not the Federal Reserve member banks. Unless the monstrocity which is the financial system overhaul as envisioned by the administration passes and gives the Fed power to do just about anything (it already does just about anything, with its charter gets amended constantly) on any industry that it declares is related to "finance" (thus any on-going business entity would be the fair target), the Fed has no authority over them.

Financial Times notes,

"Fed officials believe that there may be appetite among money funds to lend the money, since these funds are under pressure from investors and regulators to stick to risk-free and highly liquid business."

Risk-free? Agency bonds and MBS risk-free? Now who is going to be the bag holder?

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