Fed Said to Consider Clearing Banks, Facility to Drain Reserves

Oct. 9 (Bloomberg) -- The Federal Reserve is considering accessing money market funds through clearing banks or creating a facility to drain the record amount of cash added to the financial system, according to people familiar with the plans.

Those methods may help conserve the capital of the 18 primary dealers that act as Counterparties for Open market transactions as the Fed removes some of the more than $1 trillion the central bank pumped the economy, said the people, who Declined to be identified because no decision has been made.

Dealers would face constraints on capital if they were the sole Counterparties on all the so-called reverse repurchase transactions while they’re still repairing balance sheets after booking losses and writedowns in the aftermath of the worst financial crisis since the Great Depression. In a reverse repo, the Fed sells securities for a set period, temporarily decreasing the amount of money available in the banking system.

“One of the goals could be that the Fed is trying to distribute paper without encumbering dealers’ balance sheets while utilizing existing distribution channels” to expand the transactions to money markets, said George Goncalves, chief fixed-income rates strategist in New York at primary dealer Cantor Fitzgerald LP.

Discussions on how to access a broader array of Counterparties other than primary dealers are still developing, said one of the people with knowledge of the situation. Deborah Kilroe , a spokeswoman for the New York Fed, Declined to comment.

Needed Securities

The Fed, after purchasing about $1.33 trillion in mortgage, government-housing agency and Treasury debt, would also be supplying Short-term assets to the money markets at a time when corporate issuance has Declined and following the expiration last month of a federal guarantee on money funds.

Fed Chairman Ben S. Bernanke and fellow policy makers face the challenge of decreasing the cash without stunting the economy’s recovery and before it sparks inflation. The central bank’s balance sheet surged by $1.16 trillion in the 12 month period ending August, according to Fed data.

Central bank officials have started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system through the use of reverse repos agreements, people familiar with the discussions said last month. At maturity, the securities, usually Treasury, mortgage- backed and agency debt, are returned to the Fed, and the cash to the dealers.

Tri-Party Market

The value of the transaction is listed as an asset on the dealer’s balance sheet, and stays there even if a dealer uses the so-called tri-party market to enter into an agreement with another firm for the security, reducing the amount of capital that can be allocated for other Investments.

In a tri-party arrangement, a third party known as a clearing bank functions as the agent for the transaction and Holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. , both based in New York, are the only banks that serve in a trade-clearing capacity in the tri-party repo market. When dealers use repos to borrow money from institutional Investors, it is through tri-party repo.

“The Fed has used reverse repos with dealers in the past but it has never been on the scale that is being talked about here,” said Alex Roever , head of Short-term debt strategy at primary dealer JPMorgan in New York. “Operationally, it would be much easier to use the primary dealers to arrange reverse repo with money funds, but capital considerations interfere here.”

‘Range’ of Counterparties

Bernanke told Congress in July that the Fed may step beyond primary dealers and conduct the reverse repurchase agreements government-sponsored enterprises or a “range of other counterparties.”

Fed Vice Chairman Donald Kohn said Sept. 30 that “draining reserves at some point also will be an aspect of exiting.” He added, in remarks at a conference sponsored by the Cato Institute and the Shadow Open Market Committee in Washington, that “we are developing new techniques for draining reserves, including reverse-repurchase agreements against mortgage-backed securities and time deposits for banks at the Federal Reserve.”

The Fed created 10 emergency programs to support the financial markets since the collapse of the subprime mortgage market triggered a global credit squeeze, including the Term Asset-Backed Securities Loan Facility, or TALF, where Investors receive loans from the Fed to buy asset-backed securities.

“If we were to get additional supply from the Fed, that just adds to what’s been a dearth in supply and would be very much welcome,” said Debbie Cunningham, head of taxable money market funds at Pittsburgh-based Federated Investors Inc., the third-biggest manager of U.S. money funds. “The market has shrunk a lot for acceptable securities for purchase in money market land.”

Commercial Paper Decline

The amount of Commercial Paper outstanding has decreased 32 percent to $1.23 trillion since the collapse of Lehman Brothers Holdings Inc. in September 2008, Fed data shows. Commercial Paper, used by companies to pay everyday expenses such as payroll and rent, typically matures in 270 days or less.

The Treasury ended its insurance program for money market mutual funds on Sept. 18. The program was started last year as the credit market froze following the Sept. 16 collapse of the $62.5 billion Reserve Primary Fund, which lost money on debt issued by Lehman. The fund’s demise triggered a run on the industry.

“A program that enables money market funds to aid the Federal Reserve is an intriguing idea,” said David Glocke, head of taxable money market investments at Vanguard Group Inc. in Valley Forge, Pennsylvania. “The Fed is a no-risk counterparty, and such a program could provide support for Short-term yields.”

Rate Outlook

Central bankers are unlikely to drain cash out of the banking system until at least late 2010, said Ira Jersey , head of U.S. interest-rate strategy in New York at primary dealer RBC Capital Markets.

The median forecast of 57 economists surveyed by Bloomberg News from Sept. 3 to Sept. 9 is for the first Fed rate increase to take place in the third quarter of 2010.

“The Fed has many options available to change the composition of their liabilities and reduce the monetary base, with reverse repos being only one,” said Jersey. “The Fed may need alternative sources to drain liquidity.”

---With assistance from Christopher Condon in Boston and Rebecca Christie in Washington. Editors: Dave Liedtka, Robert Burgess

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net ; Craig Torres in Washington at ctorres3@bloomberg.net