April 14 (Bloomberg) -- The dollar isn't the only casualty of the Federal Reserve's rescue of seized-up credit markets. Bond traders are finding there is nothing special about Treasuries anymore, now that the Fed accepts substitutes for government securities as collateral -- having concluded it wasn't enough to reduce the benchmark interest rate for overnight bank loans six times since September.

As recently as March 21, Treasuries were in such demand that traders were willing to lend cash at rates 2 percentage points less than the Fed's target for overnight loans if they could obtain the securities as collateral. Now, the gap is back in line with the 0.06 percentage point average in the 10 years prior to August, when subprime mortgage losses spread.

The $6.3 trillion-a-day repurchase agreement, or repo, market is a barometer of sentiment because it's where firms finance trades. A narrowing of the spread between the so-called general-collateral and federal-funds rates may suggest declining demand for U.S. government debt. Treasuries have lost 0.8 percent on average since March 20, when the central bank expanded the type of debt it would take in return for the securities to include mortgage and commercial real estate bonds.

``It is an indication that the markets continue to lurch uneasily back toward normalcy,'' said Ward McCarthy, a principal at Stone & McCarthy Research Associates in Skillman, New Jersey, and a former chief financial economist at Merrill Lynch & Co. and senior economist at the Fed. ``The pressure in repo trading has finally begun to ease.''

General Collateral

Securities that can be borrowed at interest rates close to the Fed's target rate are called general collateral. Notes and bonds that are in the highest demand are called ``special'' by traders because rates on loans secured by these securities are lower than the general collateral rate.

The Fed is making as much as $200 billion in Treasuries available for 28 days through its Term Securities Lending Facility, allowing dealers to pledge mortgage-backed securities as collateral for the first time. As a result, they will be able to rid themselves of the debt while gaining sought-after U.S. government bonds. It is one of three lending programs Fed Chairman Ben S. Bernanke created since mid-December.

His boldest move came March 16, when the central bank agreed to support JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. to prevent the fifth-largest U.S. securities firm from failing after lenders refused to extend credit and customers fled.

`Fire Sale'

``The Fed's actions have potentially prevented a fire sale of non-Treasury assets,'' said Kurush Mistry, an interest-rate strategist at Lehman Brothers Holdings Inc. in New York, one of the 20 primary dealers that trade directly with the New York Fed. ``Getting Treasuries is akin to getting financing.''

Since dealers typically use repurchase agreements to finance their holdings, movements in the rates affect the cost of holding the securities in inventory. Dealers last month increasingly let trades involving Treasuries go uncompleted because the cost to obtain the securities became too expensive.

Failures to deliver or receive Treasuries, known as fails, totaled $2.3 trillion in the week ended April 2, the highest since May 2004. Fails averaged $173.6 billion a week since July 1990, data on the New York Fed's Web site show.

The general collateral rate increased to 2.25 percent on April 9, from 0.9 percent on March 20, according to data from Jersey City, New Jersey-based GovPX Inc., a unit of ICAP Plc, the world's largest inter-dealer broker. The Fed's target rate held constant at 2.25 percent during that period.

Hoarding Cash

Banks and securities firms are still hoarding cash after racking up almost $250 billion of losses and writedowns since the start of 2007.

The spread between the rate banks charge for three-month loans denominated in dollars and the overnight index swap rate, a measure of banks' willingness to lend, widened to 81 basis points today, or 0.81 percentage point, from 57 basis points on March 18. The low this year was 24 basis points on Jan. 24.

``Banks are still having to pay up to borrow,'' said Mark Amberson, the director of short-term investments and manager of the $7 billion Russell Money Fund at the Russell Investment Group in Tacoma, Washington. ``In this environment, which is dominated by fear and lack of trust, you are still seeing demand for government debt.''

`Very Edge'

Former Fed Chairman Paul Volcker said Bernanke's decision to back the Bears Stearns buyout by providing guarantees on $28 billion of loans took the Fed ``to the very edge of its lawful and implied powers, transcending in the process certain long- embedded central banking principles.'' Volcker, chairman of the Fed from 1979 to 1987, made the comments in a speech to the Economic Club of New York on April 8.

Bernanke, who worked with Treasury Secretary Henry Paulson to broker the bailout, defended the move during testimony to Congress this month as necessary to prevent ``severe'' damage to financial markets.

Fed and Treasury officials are considering ways to replenish the central bank's supply of U.S. bonds if needed to ensure the Fed can keep lending to Wall Street dealers. The Fed is selling some of its Treasuries to finance its lending programs.

Treasury bill, note and bond holdings at the Fed fell 21 percent to $560 billion on April 9 from $713 billion on March 5, said George Goncalves, chief Treasury and agency debt strategist at Morgan Stanley in New York. The firm is a primary dealer.

One option would be for the government to sell more debt and deposit the proceeds with the Fed, according to a Treasury official and two people at the central bank familiar with the proposal. The Fed would then use the cash to purchase Treasury notes, which it could lend to dealers.

``The needs for Treasuries were there and they were met with supply from all angles,'' Goncalves said. ``It's taken some of the pressure off overall Treasury general collateral funding and that in turn has partially reversed some the specialness factor attributed to Treasuries.''

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net.

Last Updated: April 14, 2008 10:11 EDT