The Fed Is Buying Mortgage-Backed Securities? Hoisted from Comments

PSP: Hoisted from Comments http://delong.typepad.com/sdj/2007/08/central-banking.html#comment-79038528:

Fri morning's N.Y. Times online edition:

The E.C.B. injected another 61 billion euros ($84 billion) into the banking system, after providing 95 billion euros the day before. The Federal Reserve today added $19 billion to the system through the purchase of mortgage-backed securities, then $16 billion in three-day repurchase agreements. The Fed also added money on Thursday.

I thought the Fed only bought and sold Federal debt. This says it is intervening directly in the mortgage-backed securities market. Is this as unusual as I think it is?

Yes.

Comments

[Dane Janeiro]

So the economic disincentive for engaging in patently risky behavior is...can anybody answer that? (In Ben Stein-like monotone) Anybody? Anybody?

[Stephen Cecchetti]

Brad,
There is a big distinction between outright purchases and collateral taken in repo. On the former, you are basically right that the Fed only holds US Treasuries (although if you look closely you will see that in the past that purchased agencies outright as well). What they are doing in repo is taking collateral.

[Ah. Thanks. Bloomberg had it as a *purchase*, which would have been unusual both in size and in manner...]

This is not "intervention" since they are going to give the stuff back. In the case of todays (admittedly very large) $35 billion operation, it will all automatically reverse on Monday.

A quick look at the history of these temporary open market operations shows that they have been taking mortgage-backed securities as collateral for repo for some time. In the past 30 seconds I could verify that they have been doing it regularly since at least 2000. The quantities have normally been small (between $100 mil and $2 bil), but they have been doing it.

So this is not what I would call an "intervention in the mortgage-backed securities market". And it is not unusual.

If you are interested in the data, you can download it from
http://www.newyorkfed.org/markets/omo/dmm/temp.cfm

Steve Cecchetti

[Rob]

But by doing something of this magnitude very publicaly they are intervening directly. If the mortgages continue to tank the Fed will be the one absorbing the losses.

[PSP]

Is the Fed buying in the market or directly from a cash strapped institution? And, how would we know?

[Dan]

Steve's comments are interesting, and I won't claim to be an expert, but won't the Fed still absorb the losses in the meantime? And if they do it again Monday? I wish there were more transparency here.

It looks like they're creating a huge moral hazard: The markets are up ~25% over the past year and a half while all this was going on. They should allow that to unwind...

[knzn]

Rob: "If the mortgages continue to tank the Fed will be the one absorbing the losses."

Only if the Fed's repo counterparty defaults (fails to repurchase as the agreement requires). That sounds highly unlikely to me even if mortgages do continue to tank.

Dan: "won't the Fed still absorb the losses in the meantime?"

I don't think so, but that's just an accounting issue. Even if the Fed were to account for losses on collateral, the losses would be made up when the repo reverses.

"And if they do it again Monday?"

Then they have the same situation with a new counterparty (or possibly the same one). Again, the Fed won't ultimately have losses unless the counterparty defaults, which is unlikely.

[Bob Morris]

> Is the Fed buying in the market or directly from a cash strapped institution?

Most if not all of the CDOs, etc. are not available on the open market, so they'd have to be getting them directly from the holder.

[RW]

My understanding was the Fed was accepting MBSs as collateral, not CDO's and other exotica; how could one price such things for use as collateral or, for that matter, anything else?

[knzn]

I wonder if the misinterpretation, and subsequent reinterpretation, of this story has been partly responsible for the way interest rates have behaved today, falling dramatically early on and then rising back to yesterday's level. This could be a lesson about the care journalists need to take with the wording of their stories.

[drm]

I'm not an economist, but if the FED is taking the loans as collatoral aren't they then also giving them a price? Doesn't that amount to propping up the market for poor loans.

[DIS]

It is not a purchase of MBS's

http://www.newyorkfed.org/markets/omo/dmm/temp.cfm

It is a repurchase agreement. The Banks have to buy them back at the sale price plus interest.

These repos are not unusual and as you said in your previous post is just the Fed doing its job of keeping the real rate at the target rate.

What is very out of the ordinary and reflects the current nasty conditions is the scale of the action

[drm]

It may be ordinary and done in the interests of maintaining liquidity, but the Fed is in effect propping up the value of the underlying securities.

In effect the Fed saying, "hey, maybe these mortgage backed securities ain't worth the paper (or bits) they're encoded in (In any case, how can we tell the markets are no longer functioning?), but if nothing else they can still be used to kite federal funds for 3 days - and that's something".

And in fact, that seems to me is a non-trivial addition to the value of the securities.

[Neil B.]

The Fed is really a private corporation with many non-US holders; must we assume all they do is even proper servicing of US financial needs?

[Neil B.]

The Fed is really a private corporation with many non-US holders; must we assume all they do is even proper servicing of US financial needs?

[kharris]

May I just say, those who are not sure of what is going on - in this case, who have not checked the NY Fed website - are not doing anybody any favors by misconstruing Fed activity out loud. Thanks to Steve Cecchetti for setting things straight.

There was huge turmoil in markets today, following huge turmoil yesterday. Under such circumstances, mistaken statements amount to noise, messing up the signal-to-noise ratio for everybody else. So please, try to be signal rather than noise. If that is not possible, questions are preferable assertions.

[anne]

Agreed, Steve and KHarris. I too suggest there is an awful lot of noise that is effectively roiling markets for reasons and in ways I just do not understand.

[drm]

"If that is not possible, questions are preferable assertions."

Excellent point. Please read my comments above as a poorly phrased question rather than an assertion. In any case, if I understand the informed commentary, a root problem is a failure of financial markets to adequately take liquidity into account in pricing various securities. In that case, isn't liquidity a component of underlying value? And if so, isn't propping up liquidity in a market a form of subsidy to the value of the security?

[ECONOMISTA NON GRATA]

I believe that Steve is correct...

I was shocked when I heard the word "purchase" earlier in the day. However, it's six of these half a dozen of the other. Collateral, purchase, either way the Fed is left holding the bag.

Buy gold.....!

[julie]

The day's fear, TV pundits screaming at Bernanke for not cutting the Fed funds rate, CNBC anchors who do not understand the role of the Fed, open market operations, discount rate ( who sets it) and the "target fed funds" rate is noise upon more noise--breeding ignorance and panic. Thank you Professor Cecchetti for once again clearly offering explanation about the Fed and what they did today in open market operations and clarifying repurchase agreements. (I recall a speech you gave describing the how the Fed responded to 9/11.) Perhaps all of the "noise makers" should observe high school students in the Fed Challenge competition. These students understood exactly what the Fed was doing today and why. They also would tell you there is a moral hazard to "rescuing" the markets but at the same time would clearly state that the Fed will provide liquidity for the orderly function of markets.

[kharris]

By the way, the Fed's efforts have produced a remarkable cure. The funds rate has traded as low as 3.50%, down from a high of 6.00%. If, through some luck of timing, a bank funding desk had lent at 6% and financed at 3.5%, it would be making one heck of a spread. In such circumstances, there is no reason not to lend funds. That, I think, is what they were after.

Check that. Funds just shed another 50 bps. Now quoted at 3%. Yippee!

[kharris]

Make that 2%. Yes, overnight lending is back.

[kharris]

1%

[drm]

It's good to know they are teaching the important euphemisms - like "moral hazard" in highschool these days ;)

[Ralph]

To my surprise, Larry Kudlow's show today, had some good discussions about the still escalating subprime crisis. Most of his guests including Don Luskin, Stephen Moore, Michael Panzer, Larry Lindsey, Jim Cuggino, Jared Bernstein were opposed to a bailout of the bankrupt hedge funds and lenders. Even Jared Bernstein of EPI who was most alarmed by what is happening conceded that a bailout would encourage more irresponsible behavior throught the moral hazard implications though he was emphatic on the need for extra liquidity to ease the threat to the economy. The guests were divided of course on the seriousness of the crisis for the economy as a whole. There is something to be said on both sides of the question in my mind.

[Ponzi Q. Globalization]

This is confusing the hell out of me.

I crap in a bucket and try to sell it. Amazingly nobody wants to buy it. I need some money fast and somebody is willing to lend me boatloads of money using the bucket of crap as collateral (it *is* worth something after all I guess). The interest rate of the loan is lower than the going rate. The lender is willing to do this over and over again. Is the lender here losing out?

Who is losing out when the Fed does what it did today? Nobody? Tax payers?

[Ralph]

The issue of pricing for MBS's, CDO's, and other structured finance securities is suggestive of the esoteric nature of the current mortgage markets and the need for closer study by finance professionals not to mention the economics community. Economist Nouriel Roubini places a good deal of attention on this issue in his blog commentaries. By the way, I forgot to mention that on Kudlow's show today, former Fed governor Wayne Angell was taken to task by a former Atlanta Fed president and former Fed Governor Larry Lindsay for expressing overly alarmist views of the subprime crisis and its implications for the economy.

[a different chris]

>So this is not what I would call an "intervention in the mortgage-backed securities market".

OK, but we need to know what your definition of "intervention" is, then? Seems like it must be pretty technical.

Now I do understand that one think the economics profession has gotten right is that the government is responsible for maintaining liquidity in all markets (sorry gold bugs).

But my mechanic is responsible for keeping my car running, but I do not consider it normal for him to actually be working on it.

My question is where, in this liquidity-poor market, is the 19 billion going to come from on Monday? Is it slated to return from summer holiday, perchance?

[compelled_to_unlurk]

"Make that 2%. Yes, overnight lending is back."

That is tantamount to cutting the Fed Funds Target rate; they are supposed to only add just enough liquidity to maintain the rate at 5.25%. If they want to add more, they should hold an emergency FOMC meeting and cut the Fed Funds target rate.

By the way, the Fed does MBS based repos all the time. However, the rate at which they lend against UST and MBS are different though in order to reflect the relative riskiness of the two classes of securities.

[walons]

Do we know what MBS the Fed repoed? If it's Fannie/Freddie, I suspect that's a bad sign.

[Enslaved]

A Mafia figure once told me:

"Our goal is to rob every person. But, there is no way we can do it on a person by person basis. Our only alternative is to co-opt their government and use it to take their money."

It's working!

[Jeff W]

This AP writer says that the acceptance of MBS in a repo at this level is unusual, contrary to what others have posted.

Quoting the article...
"According to the New York Fed's historical data, which goes back to July 2000, the bank during that time has never injected that much money in a three-day repurchase agreement that includes mortgage-backed, Treasury and agency securities. When the New York Fed — which carries out the U.S. Federal Reserve's market operation — made its huge three-day repurchase of $81.25 billion (€59.52 billion) on Friday, Sept. 14, 2001, only Treasury securities were submitted and accepted."

http://www.iht.com/articles/ap/2007/08/10/business/NA-FIN-US-Fed-Mortgage-Backed-Assets.php

I'm still on the "crap in a bucket" question. Why is it necessary for the Fed to accept MBS in this situation? Shouldn't they be able to protect the liquidity in the broader markets using just treasuries? What is the Fed's purpose in accepting MBS at this level unless it is to prop up specific institutions or to convey confidence in this particular asset class?

If these assets (the CDOs) have lost value because of subprime defaults, how does liquidity matter anyway? They are simply worth less, but the sellers don't want to recognize their losses. Will liquidity suddenly make the seller accept less or the buyer pay more? Or is everyone waiting for the government to be the sucker, I mean lender, of last resort and pay too much for them?

[groucho]

"My question is where, in this liquidity-poor market, is the 19 billion going to come from on Monday? Is it slated to return from summer holiday, perchance?"

Fed will probably end up doing more repos with existing borrowers(exchange one repo 4 another)

[Ginger Yellow]

Jeff, much of the problem in the MBS market is one of liquidity rather than credit. In 99 out of 100 cases, if not more, mortgage bonds rated AAA are in no danger of defaulting. This isn't to say that there are no credit issues, simply that the reason the financial markets are in chaos is because nobody is bidding for these securities, so nobody is sure what they're worth. Consequently nobody knows who may be sitting on enormous mark to market losses, and nobody wants to lend to anybody else. The Fed is just injecting liquidity into the sector. In Europe the ECB accepts a wide range of collateral for repo transactions - there's nothing particularly unusual, in global terms, about accepting MBS.

"If these assets (the CDOs) have lost value because of subprime defaults, how does liquidity matter anyway? They are simply worth less, but the sellers don't want to recognize their losses."

Some have and some haven't. Many are worth less simply because other CDOs have lost value.

[Ponzi Q. Globalization]

Reading the comments I get the impression that many think what happened last week was no big deal. I have some questions.

What exactly is weird about what the Fed (and ECB) did last week? The amount? The use of collateral that is now viewed as suspect? The frequency of the repos? The fact that they were pure mortgage backed repos? The fact that the 'stop out' rates were under 5.25%?

What is the big deal?

Also, what is the down side of what they did?

[anne]

There is a danger as in 1998, of an immediate to short term liquidity need spreading to freeze bond markets, and this is a serious concern. Also, we do not understand how far the housing-mortgage weakness extends or will extend.

[anne]

http://economistsview.typepad.com/economistsview/2007/08/paul-krugman-ve.html

August 10, 2007

Paul Krugman: Very Scary Things
Edited by Mark Thoma

Paul Krugman discusses the potential for problems due to the evaporation of liquidity from financial markets over the last few days:

NY Times: In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what's happening now. ... The Fed coordinated a rescue..., while Robert Rubin, the Treasury secretary..., and Alan Greenspan,... the Fed chairman, assured investors that everything would be all right. And the panic subsided...

What's been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in ... financial instruments backed by home mortgages ... have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the last few years... The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans ... and the eagerness with which investors bought securities backed by these loans. But investors also snapped up ... junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit... First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds...

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns... Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow ... the rule rather than the exception for the past two weeks.

But yesterday's announcement by BNP Paribas, a large French bank, that it was suspending ... three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of "the complete evaporation of liquidity in certain market segments" — that is, there are no buyers.

When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can't sell its mortgage-backed securities, so it can't raise enough cash to make the payment it owes to institution B, which then doesn't have the cash to pay institution C...

And here's the truly scary thing about liquidity crises: it's very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates... It can also lend money to banks that are short of cash: yesterday the European Central Bank ... lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn't do much ... if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn't do much if the cash stays in the banks' vaults.

There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don't work. But for a variety of reasons, not least the current administration's record of incompetence, we'd really rather not go there.

Let's hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn't count on it.

[Ben Ross]

This morning's New York Times (print edition, since the paper's web site has suddenly decided to stop accepting cookies from my Opera browser) says:

"The Federal Reserve yesterday added $19 billion to the system through the purchase of mortgage-backed securities, then another $19 billion in three-day repurchase agreements."

This seems, unless I completely miss something, completely contrary to the assurances given above. It raises several obvious questions:

Purchased from whom?

At what prices?

If they are willing to buy illiquid overpriced MBSs from Citibank (or substitute a similar name), why won't they buy my neighbor's illiquid overpriced house so he can avert his own financial crisis?

[Ponzi Q. Globalization]

From the "Steal a little and they throw you in jail, steal billions and they bail you out" department.

Here's a synopsis of what I think happened. Forgive the metaphor shifting. I am too lazy to maintain constancy.

1. Financial institutions find a way of mixing carrion with food and selling it as a healthy entree. Yet again this is accomplished by having lackies in the financial health department okaying any pile of rot as long as assurances are given that it is fresh.

2. Thanks to Clintonrubinesque Democrats and Republicans of almost all stripes, regulations are weakened and regulators are told to sleep on the job. Nothing to see here boys, save the wholesome workings of 21st century capitalism. It's a fantastic free for all for the big boys and girls!

3. Lenders start to give loans to anyone knowing that they can wave Wall Street's magic wand over them and temporarily turn them into gold. Each of these loans generate money up front for the lenders. Future hurt for the many is converted into vacation homes, elite childrens private schools, expensive parties, yachts, etc. for the smart and unethical few.

4. The game continues as long as home prices rise. When the prices stop rising, the carrion takes over and the rot spreads rapidly.

5. Home prices stop rising. Doh! That was unexpected!

6. The hurt is here for the many. Having cashed out all along the way, the smart and unethical few continue to live in splendor waiting for the bailout that will add even more to their wealth.

We must face facts. Wall Street is a cess pool infested with sharks who thrive in the filth. Cess pool sharks are a necessary evil in the capitalist ecosystem. However, it's stupid to give these sharks free rein to eat anything they want and grow fat and strong enough to run not only the cess pool but the rest of the world. BTW, Democrats have been swimming with these sharks far too long.

We must also all realize that fancy and smart people can be scumbags as much as the 'lower orders'. These scumbags from the upper classes just have the tools, connections, and polish not to be exposed for the criminals they are.

[anne]

Please set down any contrary or confusing New York Times reference, because the matter is important and there is considerable confusion, but the Federal Reserve is not buying up mortgage debt. However as Steve Cecchetti has written the Fed will accept quickly maturing mortgage debt as collateral. The Fed is only providing liquidity for financial transactions, not in the least buying suspect debt.

[Uncle Bruno]

What happens when/if the debt isn't repaid? The Fed holds a bag of worthless MBSs?

[anne]

The Federal Reserve will be repaid almost immediately with interest and the collateral is in any event amply valuable. There is no danger in liquidity provision, which is a daily occurrence only magnified at present.

Ponzi, enough with the crude metaphors. Enough!

[Ponzi Q. Globalization]

To make things a bit more explicit, WRT to #s 3 & 4 in what I posted earlier. The very granting of the super risky loans caused the housing prices to be driven up for a while, strengthening the cycle. My assertion is that this was done knowingly in a pyramid schemish sort of way.

One marvels at the dishonesty and/or incompetence of many of our financial authorities. The question if it is dishonesty is: Are they that beholden to or in cahoots with the titans of Wall Street? The question if it is incompetence is: Are they that naive to trust the assurances of the soundness of a system they do not understand when the assurances are given by the very people who profit from the continuation of the system?

[Ponzi Q. Globalization]

"Ponzi, enough with the crude metaphors. Enough!"

I'm sorry, anne. I'll try to lay off the crude metaphors. Lord knows I'm a terrible writer.

However, every neuron in my brain dedicated to figuring out human motivation and nature, tells me that the titans of Wall Street are out to line their own pockets plain and simple. And they will do so even if it screws millions of people. Is there anything in Wall Streets history to make one think differently?

DeLongs crazed alpha ape rants about politicians applies here too I think. These Wall Street guys are not looking out for your interests or mine. They are crazed alpha apes who want to be on top. And, for them, on top means having the most wealth. Given the economic system that has arisen, we need such alpha apes. But we also need to keep such alpha apes on a leesh.

First things first. We all must quit worshipping these necessary evils and show them the disrespect and disdain they deserve when they eff with the system in so horrible a way. Hell, I'm willing to show disrespect and disdain when they carry out their normal unwholesome activities ;-)

[anne]

Thank you; complain away however, since the complaint are easily warranted and useful, and you write well enough in any event to be highly effective. Complain away, for what you are complaining about is bothersome and shows not just a regulatory looseness that I do not understand but a heedlessness among professional investors that further bothers me.

[anne]

Brad DeLong has been bothered, as Paul Krugman, by the supposed risk blindness of regulators and institutional investors. Brad asks why financial competition alone is not enough to mitigate needless institutional risk by controlling investor costs as Vanguard so controls.

David Swensen, Warren Buffett, Charles Munger, John Bogle ask the same questions.

What are we missing about the structure of the investment market?

[Outlandish Josh]

Quick search and excel sum on historical data shows that the NYT article is misleading using the words "purchase" and "repurchase" in the same sentence, as both the $19B operations (it was actually a 19, a 16 and a 3) on the 10th were the same type of deal.

However, to get a sense of scale, in the whole month of July, the fed RP'ed only $24.2B worth of Mortgage-Backed Securities.

A bailout (if it comes, which I would say is likely given the overall situation, but hardly inevitable) will be more obvious and very politically charged, no doubt.

[Ben Ross]

Here's the link to today's Times article:
http://www.nytimes.com/2007/08/11/business/worldbusiness/11markets.html

Here's last night's Bloomberg report which says it's a repo:
http://www.bloomberg.com/apps/news?pid=20601103&sid=a9hrkahO0I3I&refer=us

I find it hard to just wave off the Times report. The alarming assertion that there were purchases, rather than repos, is repeated, more clearly, on a second day. People at the NY Fed read the Times. It's very hard for me to conceive that, if the Times was wrong yesterday about something so important, they wouldn't have gotten a complaint about it from somebody and not repeated the mistake today. (As opposed to the relatively soothing Bloomberg report, which if erroneous those in the know might have preferred to leave unchallenged.)

Question to those checking Fed databases: If this were in fact a purchase of MBS's, is there another place where it would have been reported, where you do in fact see a zero, or is this so unprecedented that the database you are looking at doesn't have a place to report it? In the latter case, have you excluded the possibility that this was a purchase and was reported as a repo because that was the only place to report it in their database?

[Ponzi Q. Globalization]

Relating to another bubble we all miss...

On Book TV (C-Span2) @ 6pm an encore presentation from 1999 of (drum roll please):

Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market

with author James Glassman

http://www.booktv.org/program.aspx?ProgramId=8548&SectionName=Encore%20Booknotes&PlayMedia=No

Should be a hoot!

Here are some other wonderful statements from the great man..

"It has been a war unmatched in history, with relatively few civilian and allied casualties and the prime objectives - control of the capital and the destruction of Saddam's regime - achieved in only a few weeks."

I guess when it comes to the deaths of people "few" is defined as "thousands" in Glassmans dictionary.

"Maybe it's time for a different kind of Stop the War parade in Washington - a victory march."

http://www.capmag.com/article.asp?ID=2677

Rah rah rah! Such glory! And for so little blood. Well, I should say real (i.e. American) blood, not Iraqi.

I wonder if Jimmy felt the thrill of victory do laps around his nether parts? Little did he know that it was only the beginning of all the thrills and fun!

Warmongering corporate capitalist suckup twit.

[anne]

Now, there's an imaginative writing :)

[anne]

http://www.nytimes.com/2007/08/11/business/worldbusiness/11markets.html

The Federal Reserve yesterday added $19 billion to the system through the purchase of mortgage-backed securities, then another $19 billion in three-day repurchase agreements....

[Thank you, Ben. I believe this is an error in reporting, though Brad DeLong noted Bloomberg reported similarly.]

[nemo]

http://tinyurl.com/3bhcut

Treasuries Decline as Fed Acts to Ease Credit Crunch Concerns (April 11)

"The U.S. central bank conducted its so-called open market operations earlier than usual yesterday, shortly after 8 a.m. in New York, lending $19 billion to dealers and accepting all forms of collateral. It later lent $16 billion and $3 billion. The central bank added $24 billion on Aug. 9.

"The central bank normally conducts so-called separate repurchase agreements in which it specifies Treasury, federal agency or mortgage-backed debt as the lowest-quality collateral acceptable, said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.

"Yesterday's agreements accepted all forms, meaning that dealers probably delivered only mortgage-backed securities, enabling them to retain their Treasuries at a time when those securities are in high demand."

[David]

Ponzi, I really like your posts. Your overview helps to illuminate what's really going on.

[Fullcarry]

When any institution does a short term REPO it is common to refer to it as the buyer of the collateral.

Most institutions of course do a REPO because they are short the underlying collateral and need to cover their short. When they take the collateral in they lend cash out.

At the time of the transaction it is always decided when the collateral will be returned, the price and the level of interest.

Treasury collateral is very tight right now. Massive amounts have been bought by foreign central banks that do not lend out. If the FED had tried to add liquidity by REPOing treasuries it would have exacerbated the spread widening already stressing the markets.

Finally REPOed collateral gets repriced daily. If the price of the underlying collateral changes the counterparties exchange cash to reflect that repricing.

[azurite]

If as knzn suggests, that the Fed may (that's may) do another repo agreement with the same or different parties on Monday if the Fed feels it's necessary, what are the banks actually paying back? Do they actually pay interest? Or does it become more like ongoing loans for the same collateral?

Are these loans issued with a condition that the money be loaned out (and if so, are there any guidelines or conditions, like no more CDOs containing subprimes?) otherwise, what is to stop the banks from mostly sitting on the money, as Krugman states may happen? Or at least he's concerned it might happen.

I'd say that, to some extent, Ponzi's metaphors hit the nail on the head. I'll add that elite private schools aren't all they buy--they also build huge second and third homes, buy planes and fly them illegally low, land them on beaches illegally and in general behave as though rules and laws are for other people--the working peons.

[kharris]

Jeff W,

The AP writer should have noted that this is the largest such operation in half a decade, regardless of the type of collateral involved. The writer's implication that Friday's operations were remarkable because of the collateral involved seems a bit of a logical error. It is remarkable due to its size, manner of execution and result, but not because of the type of collateral, unless the type of MBS accepted as collateral today is unusual in prior open market operations. That said, it was surely not a coincidence that MBS paper was overwhelmingly the form of collateral accepted.

Groucho,

The reason so much was done Friday was that the overnight rate had reached 6%, and the Fed wanted to get it back down. After the first two operations, funds traded at 5.25% through much of the normal session, so that worked. To my knowledge (which may not be all that good) the source of the spike in overnight rates Friday was a desire among banks to hold more reserves. If that desire persists, the Fed is very likely to do as you say and roll over Friday's operations on Monday – keep liquidity higher than it had been prior to Friday. If banks were only getting spooky ahead of the weekend, they will go back to normal overnight lending practices, there will be too much cash and the Fed will allow Friday"s RPs to expire, rolling over only a normal amount in new operations.

Uncle Bruno,

Participants in the overnight market are generally good for the money in the very short term, which is the relevant time frame here. Think of the Eurodollar market, which is similar to the funds market, except that there is no collateral involved. Steve Cecchetti would know better than I do if there has been a default on a transaction in the Fed funds market, but if so, it was a very rare happening. A bank that defaults in the funds market is no longer a bank.

Ben,

The Fed does a thing called a "coupon pass" to make a (semi) permanent addition to the monetary base. It is an outright purchase of debt instruments. The NY Fed website calls what happened Friday repurchases, and refers to the MBS paper bought as collateral. It was not a coupon pass. The Fed bought no paper outright on Friday.

[Matt]

Does anybody have any insight into which specific banks were counterparties in any of these repurchase agreements? How about any info on the situation with the ECB?

[Eduard Berenguer]

Injecting liquidity to the market, the Fed and other central banks, maybe are acting not so much as lenders of last resort as price-fixers of last resort. In other words, if markets are overreacting to the news coming from the subprime market, the price of risk is erroneous as it was before when investors believed the ratings incorporated into CDO's. So, injecting liquidity can help to fix the prices of these derivatives.