The Federal Reserve is discussing the possibility of using “reverse repo” transactions with money market funds that would be aimed at draining liquidity from the financial system. The transaction would involve swapping the toxic assets on the Fed’s balance sheet for part of the $3 trillion sitting in investor money market funds. Typically a repo transaction is a policy tool used by the Fed and executed with the Fed’s primary dealers in order the “fine tune” systemic liquidity and regulate the Fed Funds rate. They are short term in nature and involve swapping short term Treasuries in exchange for cash, with the Treasuries being the collateral in order to “guarantee” that the short term trade can be unwound with little or no risk.
Here’s the link to the article that revealed this proposal: Fed Wants To Drain Money Market Funds
The current Fed proposal is based on the fact that the primary dealer system only has enough cash to drain $100 billion from the system. Here’s what is really going on with this proposal (without getting into the technical details of how repos work):
The Fed has purchased trillions of dollars of toxic assets from banks. We don’t know what price the Fed paid and we don’t know how corrupted the underlying collateral is (the Fed refuses to disclose both pieces of valuable information). Most of the securities involve severely distressed underlying collateral like credit card receivables, subprime mortgages, auto loans and now commercial real estate mortgages. Most of these assets will eventually be worth less than 10 cents on the dollar. If the Fed were to hold onto these assets, the Fed, and the banks that ultimately are the shareholders of the Fed, stand to lose trillions.
What the Fed proposal would do would move these toxic nuclear waste assets from the Fed’s balance sheet and into money market funds, in exchange for cash sitting in the money market funds. The biggest problem is the Fed has no basis for valuing these assets other than the price it paid the banks for them, so at what price will the Fed value these securities in order to establish the market value basis for the repo transaction? In other words, the Fed can stick a random price on these assets and swap them for the cash in the money market funds and say “trust us, we’re Fed – we’ll make you whole.”
Without going in-depth into the problems that could occur which might make the Fed’s promise wothless, this proposal, if made effective, would expose money market funds to a significant, if not catastrophic level of risk. To be sure, each fund individually has charter limits which would put a cap on the amount of cash the Fed could “repo” out of the individual fund and replace it with garbage assets. However, these assets were fraudulently rated AAA in the first place and have no business being put into money market funds. Money market funds are supposed to be basically risk-free funds in which investors “park” cash and earn a small amount of interest.
At best, this is a move by the Fed to justify draining a large amount liquidity from the system by using one of its monetary tools to drain cash from money market funds. This has never been done before and is well outside of the traditional boundaries of repo/reverse repo tool used by the Fed with primary dealers. At worst, I believe this is a veiled attempt by Bernanke to move toxic assets from the Fed’s balance sheet and onto the public, under the false pretenses of using money market funds to drain liquidity from the system, rather than putting these near-worthless assets back on to the balance sheets of the Fed’s primary dealers.
Hopefully this idea goes away. If it does become reality, I would not, under any circumstances trust this situation and would withdraw all funds from any money market funds you own and either move the cash into gold or into a short term Treasury bond fund.
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