The Lender of Last Resort By: Gabriel PotterMBA, AIFA® 2019.09.24

I’m sure most of our readers remember the financial crisis of 2008.  You may remember the explanation of the problem and you almost certainly how it made you feel, but have you lost some of the minutiae over the past 10 years.

One element I’ve been happy to ignore for the past decade is the seizing up of short-term credit lending during the worst of the crisis.  When Wall Street problems affected the profit margins huge banks, the ordinary American can be forgiven for asking, “why should I care?”  However, when losses became sufficiently larger, banks began hoarding their assets and stopped lending money to one another. Then the overnight repo market, critical to day-to-day business operations for thousands of companies, stopped working.  Payrolls can stop and a vicious cycle of diminishing economic activity can push the economy over a cliff.  Ultimately, the markets had to rely on government interference and the Federal Reserve – acting as the lender of last resort – to backstop the market.

We thought we should let you know it’s happening again.  Over the past week, the Federal Reserve has had to back up the repo market.  The repo market is misfiring for a variety of reasons.  First, the supply of liquid cash in the system has leveled off since the Fed stopped the quantitative easing program.  Second, the repo market is targeted to receive less return for lenders as a result of interest-rate cuts; since the financial markets aren’t clearing at the Fed’s targeted rate (near 2%) and cash deals are spiking at much higher rates (8%).  So, the Fed is stuck trying to defend its unnaturally low interest rate target with cash injections. 

Unlike 2008, this isn’t because banks are hoarding money due to losses.  However, the Fed is already having to backstop the market.  By itself, this isn’t a core cause for alarm.  However, if the Fed is already taking on extraordinary measures to support an economy where everything is humming along. What actions can they effectively take if there’s even a small stumble in the future?  If banks have this little of a cash cushion, what happens if there’s additional stress from bad loans or delinquencies? Many signs point to an inevitable economic slowdown.

 

 

 

 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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