A Treasury Shortage Squeezes the Heart of the Market

New rules may put a crimp in crucial overnight lending
Illustration by 731

Considering the trillions of dollars of Treasury bonds the federal government has been selling to pay for its budget deficits, you’d expect there to be plenty of them for use by dealers in the financial markets. Instead there’s a drought, one that’s likely to get worse before it gets better, and it’s already interfering with the functioning of what an adviser to the Treasury Department in a recent document called “the silently beating heart of the market.”

The shortage is a result of a decline in Treasury issuance as well as banks’ strengthening their balance sheets in preparation for rules designed to prevent a recurrence of the 2008 financial crisis. The rules, likely to take effect next year, will further reduce liquidity in the Treasury market and could have the unwanted side effect of slightly pushing up borrowing costs and making interest rates more volatile. “You could argue that you’ve reduced systemic risk,” says Joseph Abate, a money-markets strategist at Barclays. “But when liquidity in the Treasury market goes down, that translates into higher mortgages and reduced access to consumer credit.”

Treasury securities play a central role in high finance—the “beating heart” that the Treasury Borrowing Advisory Committee described—because they’re all but certain not to suffer default and are easy to buy and sell in large quantities. A hedge fund or bank that wants to borrow $100 million overnight to make a payment or speculate will pledge some of its holdings of Treasury bills, notes, and bonds as collateral. Technically it sells the Treasuries and buys them back at an agreed-upon price in what’s called a repurchase agreement, or repo. Money-market funds, pension funds, and insurance companies that have excess cash will take the other side of the repo transaction—lending the $100 million and temporarily taking the Treasuries as security. Often they will reuse the collateral they receive by pledging it as collateral for a loan of their own. The big banks serve as middlemen.

Wall Street is frighteningly reliant on short-term borrowing to finance what are often long-term investments—which is why a freeze in the short-term lending markets can be catastrophic. During the 2008 credit crisis, Treasury-backed lending never went away, but there was a dramatic decline in repo loans backed by assets such as mortgage-backed securities because lenders lost faith in the quality of borrowers’ collateral. That abrupt drying up of nonbank credit was a factor in the worst economic downturn since the Great Depression.

U.S. regulators as well as the Swiss-based Bank for International Settlements are tightening standards for repo lending to prevent a repeat of the meltdown. Repo lending and related forms of finance such as commercial paper are known as shadow banking, because they operate in parallel with the deposit-taking and lending that conventional banks do. The new rules covering leverage and liquidity will make it more costly for banks to perform their crucial middleman role by squeezing the profits out of “low-yielding, high-volume activities” such as repo dealing, says Hugh Carney, senior counsel at the American Bankers Association.

Treasuries will be in shorter supply because regulators won’t allow lenders to reuse the securities they receive as collateral to secure loans of their own. What’s more, new rules aimed at making derivatives trading safer will require traders to post hundreds of billions to trillions of dollars of high-quality collateral, further draining the pool. “The banks are the guys who are playing the role of the big shock absorber,” and the new rules will create a “real trade-off between bank safety on one hand and market functioning on the other,” says Gregory Whiteley, who manages government debt at DoubleLine Capital.

Even though the rules have yet to take effect, Treasury bonds have been scarce this year. Repo lenders usually earn interest. But frequently in 2013 they have paid borrowers in their eagerness to get their hands on their Treasury collateral, which they then use for secured borrowing, hedging, speculating, and other varieties of financial engineering. On June 4, for example, the overnight repo rate on 10-year Treasury bonds closed at –3 percent annualized, according to data from ICAP, a broker. “Unless they want to regularly issue more 10-year notes, which is unlikely, I don’t think there is really much they can do,” Barclays’s Abate said at the time. In government debt auctions, there have been five bids for each six-month Treasury bill for sale, up from a 2-to-1 ratio a decade ago.

The abrupt shrinkage of the budget deficit this year caused the Treasury Department to cut back on issuance of debt in the shorter maturities that are sought after on Wall Street. Foreign demand has been strong, partly because some European government securities that had been used as collateral are no longer considered safe enough. Finally, the Federal Reserve, in its efforts to stimulate the economy, has been soaking up $85 billion a month of Treasuries and mortgage-backed securities. Some market participants argue that the Fed is planning to taper its bond purchases in part to relieve the collateral scarcity.

Shadow banking such as repo lending is too important for regulators to shrink it drastically, says Pete Crane, the president and chief executive officer of Crane Data, which follows money markets. He says regulators are suffering from “ultra paranoia.” Even if they tried to shut down shadow banking, he says, it would reemerge, possibly in more dangerous forms. Carney, the American Bankers Association lawyer, makes a similar point: “There is a fear that a lot of these activities will flee outside the purview of the regulatory agencies.” After seeing what happened in 2008, though, regulators have decided that shadow banking is potentially too destabilizing to be left alone.


    The bottom line: Wall Street is so eager for Treasuries that there are five bids for every six-month T-bill, up from two a decade ago.

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