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Fed Plans to Ease Funding Pressures by Adding Cash

By Ye Xie and Craig Torres
Bloomberg News Service
Monday, November 26, 2007

NEW YORK -- The Federal Reserve will provide funds for banks to borrow in an attempt to forestall any cash shortages at the end of the year, its first such operation since December 2005.

The Fed's New York branch said in a statement that it plans a series of repurchase agreements, starting with an $8 billion injection on Nov. 28, extending into next year. The move follows the European Central Bank's commitment last week to make extra cash available to "counter the re-emerging risk of volatility" in money markets.

"The Fed is pulling out all stops to try to alleviate funding pressures in the money and financing markets as the markets lurch into year-end," said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.

Fed officials acted after the average U.S. overnight lending rate between banks exceeded their target seven of the past eight days, suggesting a reluctance to lend amid mounting subprime mortgage losses. In most years, banks face year-end pressures as they adjust their books to show ample liquidity and at the same time meet a jump in demand for cash from consumers.

The New York Fed said it planned the steps "in response to heightened pressures in money markets for funding through the year-end." Officials will "provide sufficient reserves to resist upward pressures" on the benchmark federal funds rate around year-end. The Nov. 28 repo will mature on Jan. 10.

...'Still Fragile'

Policy makers judged that financial markets were "still fragile" when they met to set interest rates Oct. 30-31, according to minutes of the session released last week. "Unusual pressures in funding markets persisted," the Fed said.

The cost of borrowing dollars for three months rose for a ninth day to 5.05 percent in London today, the British Bankers' Association said. That's 55 basis points more than the Fed's benchmark rate, the widest gap since the Fed cut its benchmark rate for the first time in 4 1/2 years on Sept. 18.

Fed Chairman Ben S. Bernanke will have an opportunity to comment on market developments when he speaks Nov. 29. The central bank today expanded the scope of his remarks to include the national economic outlook. Previously, he was scheduled to give acceptance remarks for the Charlotte Chamber's Citizen of the Carolinas Award and speak about the regional economy.

...August Collapse

Fed officials in Washington, who confer daily with the New York Fed's System Open Market Operations desk, have been attuned to funding shortages since the credit-market collapse in August.

On Aug. 10, the central bank pledged to supply additional reserves as needed to address funding constraints. The Fed also reduced the discount rate, the charge for direct loans to banks, to a half-point spread over the federal funds rate on Aug. 17. The gap is usually 1 percentage point.

Policy makers also lowered the main rate by 75 basis points in their past two meetings, to 4.5 percent, in an effort to cushion the economy from the credit crunch and housing recession. The discount rate is 5 percent. A basis point is 0.01 percentage point.

Central bankers next meet to set rates Dec. 11. While Fed Governor Randall Kroszner and other officials have expressed skepticism on the need for additional rate cuts, traders are betting on them.

Fed funds futures contracts show an 84 percent probability of a quarter-point reduction next month, with a 77 percent chance of a further rate cut in January.

...'Magic Bullet'

"Given the heightened state of credit aversion going on it looks like the only magic bullet that they have to help the markets is a rate cut," Rupkey said.

Fed officials may be drawing on the playbook developed for the 1999-2000 millennium year change. At that time, regulators feared that obsolescent computers would wreak havoc with the banking system. They developed the Special Liquidity Facility in mid-1999, which included longer-term repurchase agreements and the sale of options on repos.

The Fed arranged $5 billion in 28-day repos on Dec. 7, 2005, and $4 billion through 52-day repos on Nov. 15, 2004. The Fed didn't arrange such repos in 2006.

"What the Fed's trying to do here is let the market know that they will provide liquidity around year-end, which is of particular concern in financial markets right now," said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc. "So anything they can do around that should help alleviate concerns."

...Repo Agreements

In repos, the Fed buys U.S. Treasury, mortgage-backed, and so-called agency debt from its 21 primary dealers for a set period, temporarily raising the amount of money available in the banking system. At maturity, the securities are returned to the dealers and the cash to the Fed. The Fed conducts short-term repos, ranging from overnight to two weeks, almost every day to keep the Fed fund close to its target.

Louis Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said the Fed often does long-term repos spanning year-end in November and December, and they usually won't issue a statement to announce the move.

"Formalizing the procedure by announcing it, they intend to boost confidence in the repo markets," said Crandall.

In a separate statement, the New York Fed said it will raise the limits on the amount of Treasuries that dealers can borrow from its System Open Market Account. Through the account, dealers can borrow Treasury notes and bills that are scarce in the repo market.

...Higher Limit

Primary dealers will be able to borrow 25 percent of the amount available, with a maximum of $750 million per Treasury security, up from the previous limit of 20 percent with a maximum of $500 million per issue, according to the Fed's statement.

The Fed said it has also increased the amount available for borrowing each day to 90 percent of an issue from 65 percent. Dealers can also borrow securities maturing in six days or longer. The Fed had previously limited the borrowing only to issues maturing in at least 13 days.

Demand for government bonds have increased as losses tied to delinquent mortgages spread through the credit markets. The yield on the benchmark 10-year Treasury note has declined 0.59 percentage point in the past month and touched 3.79 percent today, the lowest since March 2004.

...'Crucial' Market

Raising borrowing limits will help "alleviate shortage of securities that have developed recently," Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York, wrote in a research note. "The action will in turn help maintain functionality in the $4 trillion market for repurchase agreements, a market crucial toward the financing of Wall Street's fixed-income inventory."

The New York Fed cut the minimum fee dealers pay to borrow Treasuries from the central bank to a record low of 0.5 percent on Aug. 21, from 1 percent.

In its daily open-market operation, the Fed added $10.25 billion through overnight repos today, when $6.3 billion in repos was due to mature. Wrightson had expected the Fed to add as much as $15 billion.

Repos help maintain enough money in the system to keep overnight interest rates close to the central bank's target.

The overnight rate traded at 4.625 percent today, above the Fed's 4.5 percent target rate.

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