The Excess Reserve Problem.

I have spoken about the "Excess Reserve" Problem.

http://tradersutra.blogspot.com/2009/08/treasury-fed-at-crossroads.html

http://tradersutra.blogspot.com/2009/10/lessons-from-gbp-sterling-crash.html

http://tradersutra.blogspot.com/2009/10/currency-destruction-and-quantitative.html

Bloomberg out with this piece.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aQokWJUKo2d0&pos=4

Excess Reserves on the Fed's balance sheet will soon cross the $1T mark. With continued QE asset purchases and the wind down of the Supplemental Financial Program (SPF)of the Treasury will drive this figure to $1.2T by January 2010. Other central banks are at elevated levels as well. Why is this such a problem? Well for starters, these deposits are earning little or no interest. The bigger problem from reading the Bloomberg piece above is that the banks are not lending this money out, partially because their is no private lending demand, but more disturbing is the bad shape bank balance sheets are in currently. Its nice to know that the banks are quite liquid at the moment. Too bad its not their money. If and when loan demand comes back or if the banks go out and purchase assets to drive interest rates down, its going to lead to higher inflation in the future. I only see this possibility much farther into the future. The bigger concern is the following. The banks are hoarding cash and the Fed thus has all of these toxic loans on their books, if we take it at face value that the banks are hunkering down for more rough seas, what does this mean for the FED and the banking system as a whole? It tells me that there is much more pain ahead in terms of outright losses and write downs. The banks have been weak of late. The concerns are now Commercial Real Estate. Add in uneven mortgage underwriting (MSR's) results and we have seen a roughly %15 correction in the sector(BKX).

QE or Quantitative Easing created the excess reserve problem. Starting in September 2008, central banks opened up liquidity facilities to alleviate the stress from frozen fixed income markets. In the past, such a build up in these type of reserves would have been minimizes by central banks by selling government securities. This time around, however, that was not done for two reasons. First, central banks have pursued QE with the intention of increasing the growth of money, given near zero policy rates, while more ER would push overnight rates lower. Second, the sheer size of the increase in ER relative to the size of government securities held by or available to the Fed that could be used to drain reserves was at least partly responsible for central banks not being able to drain excess reserves. Under these extenuating circumstances, the Fed even turned to the Treasury for assistance and the Supplemental Financing Program was created to help drain ER. The Fed has also been engaged in Tri-Party Repo agreements with primary dealers in an attempt to squeeze reserves out of the system.

The dealer side of the equation is much more of a problem. The Fed can continuously print money as they have been doing. But the ER problem at the banks is much more serious. Most of the dealer to dealer lending at the moment is on an overnight basis. The risks at the moment for primary dealers is not liquidity. It never was a liquidity problem from the beginning. Wall Street dealers are very nervous about future losses and write downs. This the high level of reserves in the system. Even if the banks wanted to make loans, the demand for bank credit is simply not there. This issue's will persist for some time.

Another reason for the elevated levels is that ER earn interest currently. Prior to October 2008 this was not the case. So before 10/2008, it wasn't in Wall Streets interest to keep money in ER, as it was not interest bearing. At the moment they are earning a better spread parking them.

The Fed has been making the argument that the reason for high levels of ER is because of QE, once they drain the system of these reserves, the levels can go back to norms. Its easier said then done. The Fed wanted to test some tri-party repo's with Wall Street dealers, and there were some rumors that these repo's failed. All in all, Wall Street has a great thing going at the moment, that is until the losses pile up.