Repo-Market Turmoil: Staring into the Financial Abyss?

• Repo-Market Turmoil: Staring into the Financial Abyss?
  by https://gnseconomics.com/en_US/
  One thing has been bothering us for six years. How can so many economists and economic commentators dismiss the ever-increasing market meddling of central banks so lightly? The first time we warned about this possible threat to financial markets was in December 2013. In the report, we wrote:
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  There is a serious possibility that the measures taken by the central banks have already created a situation in which their actions increase rather than decrease financial instability. This is due to the fact that if the actual price of an asset does not meet its market–based value, the true level of risk is not properly revealed.
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  The continuing turmoil in the repo-market, first triggered on 16 September, is the most recent and probably the most worrying example of this. There has been a lot of speculation about its origins. In this post we explain why we consider the repo-problems to be the first sign, a symptom, of the financial calamity we’re about to face.
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  The failed clean-up
  The global financial crisis (GFC) or “Panic of 2008” was a shock not just to bankers, but also to economists—not to speak of ordinary citizens. It was a massive failure of risk-hedging in the financial sector, combined with both regulatory failures and dangerous and deeply-embedded incentives. We  summarized the factors leading to the crisis in our blog: 10 years from Lehman and nothing has been fixed.
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  While the extraordinary measures used to stop the crisis from mutating into a systemic meltdown can be considered appropriate, the fact these measures were continued cannot. In retrospect, the U.S. did recapitalize, merge and permit the failure of some banks, but Europe choose the exact opposite approach:  undercapitalized and ailing banks were left standing.
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  However, the most crucial mistakes were made after the GFC on both sides of the Atlantic. The hidden virtue of crises and recessions is that they remove both unproductive firms and financial excess, creating space for more productive firms and fresh financial investment. This was not allowed to happen post-GFC. This also explains why the economic recovery from the crisis was so weak.
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  But the financial sector got the worst treatment.  One major central bank after another enacted zero or negative interest rate policies and started asset purchase (QE) programs run through the commercial banks. In the U.S., the Fed purchased securities from authorized Primary Dealer banks by crediting reserve balances to the Fed accounts associated with each dealer counterparty.
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  These intermediary banks paid the sellers of bonds (households, funds, banks, etc.) and the Fed compensated the banks with reserves.  In practice, the Fed forced excess reserves onto the balance sheets of banks far beyond levels they would have acquired independently.
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  Because of the higher supply of reserves system-wide, their marginal benefit decreased, bidding-up the prices of various securities. This led the banks to issue additional and often riskier loans until the balance of the marginal benefits was restored. Also, because QE and low policy rates depressed long-term rates, many of the securities that the commercial banks held had no yield advantage over reserves, making the banks more likely to substitute less-liquid securities with more credit risk.
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  read more.

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