Ben Bernanke, Repo Man

A Senate panel voted 16-7 in favor of reconfirming Federal Reserve chairman Ben Bernanke, despite the fact that many Americans feel the Fed has waded beyond what is safe in rescuing the markets.

Which is why a growing chorus of Congressmen have vowed to block his reconfirmation, despite Time Magazine naming Bernanke "Man of the Year."

Before we get to why the Fed's exit will push interest rates higher, it's a misapprehension of Time'sselection process to say its choice was premature because Bernanke has not finished the job safely dismounting out of its massive intervention into the US. economy.

Timemakes its choice based on who is driving the news during the year, meaning, which individual is noted the most number of times in news events.

Which is why it's inapt, as Republican Congressman Jim Bunning has done, to compare Time'sselection of Bernanke to Time's prior choices of Ayatollah Khomeni or Hitler.

Separate from that, most importunate for the markets is this:

Can Bernanke's Fed smoothly exit out of the economy without rocking the markets, or causing interest rates to spike higher, or triggering a double-dip recession?

Or has the Fed waded so deeply into the US economy that it can't grow organically on its own, as Wall Street analysts now fear?

Answer: Expect rates to rise.

The Fed's balance sheet, now the size of the economy of France, has doubled in size to more than $2 trillion since the crisis began in August 2007.

To keep loan rates low, the Fed has been buying Treasurys, mortgage-backed securities, and debt issued by Fannie Mae and Freddie Mac ($155 billion out of a target $175 billion), making its balance sheet, once loaded with plain vanilla Treasurys, increasingly idiosyncratic and complex.

The Fed's Colossal Footprint 

Just one example of the dangers ahead: to keep mortgage rates low, the Fed has effectively cornered the market in mortgage-backed securities, buying $1.25 trillion—two-thirds of the market of issuances with yields of 4% to 5%, notes Brian P. Sack, executive vice president of the Markets Group at the Federal Reserve Bank of New York in a recent speech.

“The Fed has been a substantial presence in these markets and has accordingly left a big footprint,” Sack says.

What should astound, Sack adds, is that “Fed purchases to date have run at more than two timesthe net issuance of securities in this market.” In all, the Fed has a total of about $1.8 trillion of Treasury, agency, and mortgage-backed securities on our balance sheet today, Sack says.

At the same time, those cash purchases have pumped liquidity into the markets, too.

The markets fear that, when the Fed's program to purchase mortgage-backed securities ends next March, 30-year rates may soar past 6%, risking another downdraft in the housing market.

Also, the Fed dropped rates to near zero last December, where they've stayed ever since. At the same time, it has essentially created with the push of a computer button more than $1 trillion in excess bank reserves in the U.S. economy to hose down a firestorm of bank insolvencies.

Now the '?too much money chasing too few goods' scenario is fast approaching Bernanke, with attendant fears that another economic downturn would struggle to get out from a leaden X-ray blanket of deep inflation--which in an economic downturn equals stagflation.

This is the most perilous time for the central bank and US economy. Because if the Fed gets it wrong, it risks a severe double dip recession or just as bad, severe stagflation. The Fed needs to move in a "timely and effective" way to avoid future inflation, Bernanke recently told Congress.

How will the Fed take back those $1 trillion in excess reserves?

The $1 Trillion Question

To remove liquidity out of the system, much of the action will be in what's called the $5 trillion-a-day repurchase agreement, or repo market, which the Fed is now testing.

Specifically, to drain the system of excess liquidity, the Fed has already embarked upon testing the repo market.

The repo market is where dealers in government securities get their short-term borrowing to enact trades. It provides vital financial plumbing for the markets. Big Wall Street investment banks and clearing desks typically fund up to half their balance sheets through the repo market in any given year.

In a reverse repo, the Fed sells securities on its balance sheet for up to $1 trillion in cash. It then pledges to repurchase those securities back at a later date, at a price that's a bit higher.

"Through the use of a short-term funding method known as reverse repurchase agreements, we can act directly to reduce the quantity of reserves held by the banking system," Bernanke told Congress in early December.

Rates Will Rise 

But can the repo market handle this action? And would the Fed's actions create a bond market crackup, driving yields higher, and in term short-term interest rates higher?

Is the market deep enough to absorb these bonds?

Key here, too, is who will buy all of these bonds? Who will want them, some of the most damaged stuff there is? And will rates spike higher, since all those debt securities will be clamoring for the same investors, so they'll have to offer more in the way of yields to lure buyers in?

"In all cases, the program will compete with other short-term investments and put upward pressure on Treasury bill rates," a member of the Treasury Borrowing Advisory Committee noted, as cited in the group's November minutes, Reuters reports.

Moreover, banks are already investing in T-bills, instead of lending to risky borrowers. But if there are more debt securities to invest in dumped on the market, that “may dampen the demand for Treasury securities,” the member said.

Also, as the supply of Treasuries increases, which occurs when reverse repos take place, repurchase agreement rates are typically pushed higher, driving costs to the Fed higher.

The overnight general collateral repurchase rate, which is typically a few basis points below the fed funds rate, opened at 0.20% recently, versus a fed funds rate at an average 0.17%, Sack noted, citing GovPX Inc., a unit of ICAP Plc. A basis point is 0.01 percentage point.

Economist Kenneth Petersen estimates the Fed theoretically would be able to drain several hundred billion of dollars from its balance sheet for up to two years, which he notes is the typical length of term repos.

Joseph Abate, a money market strategist in New York at Barclays Plc, a primary dealer, reportedly told Bloomberg. “To be effective, the Fed would have to drain several hundred billion dollars worth of funds through these reverse repos, between about $400 and $600 billion,” Abate has told Bloomberg.

“You may have a dislocation in the repo markets due to the supply effect of the Fed injecting such a large amount of extra collateral into the marketplace,” he says. Meaning, rates may spike higher.

The issue, though, is the regular players like JPMorgan Chase or Bank of New York Mellon may not have the balance-sheet stomachs to absorb these securities now.

Who Can Come to the Fed's Party? 

So the Fed likely would have to engage “with more counterparties than just its usual primary dealer counterparties -- as the primary dealers may not have the interest or the liquidity to engage in large trades,” Petersen notes.

More trading partners may be needed since primary dealers have been shrinking their balance sheets the past two years, and likely can't absorb an additional $500 billion of securities, according to Abate at Barclays.

The Fed has already explored tapping the $?3.?3 trillion money market mutual fund industry, which craves higher yields now to satisfy investors; another possibility is, get this, Fannie Mae and Freddie Mac.

Bonds in Orbit

A heck of a recycling job. Bonds could be orbiting, round tripping between the Fed and Fannie and Freddie for some time.

But Petersen warns that as the Fed drains its balance sheet, the effective Fed funds rate would naturally move higher. “This could convince banks to increase their prime interest rate, which again would make home equity lines of credit, credit card loans, car loans, and student loans more expensive,” Petersen says. So that means rates would go up.

Another option is to raise the interest rate on reserves that banks have parked at the Fed. That would stop the banks from flooding the system with those reserves. The Fed recently put up a trial balloon for a term deposit facility, where it pay a nominal rate of interest to banks to lock up reserves, at, say, a quarter of a percentage point.

Translation: the Fed would effectively cause rates to go higher because it is opting to pay banks to keep money out of the system, including money for loans, in order to avoid inflation. That is political dynamite.

"Banks will be unwilling to make overnight loans to each other at a rate lower than the rate that they can earn risk-free from the Fed, and so the interest rate we pay on banks' balances will tend to set a floor below our target overnight loan rate and other short-term interest rates. Banks generally will not lend funds in the money market at a rate lower than they can earn risk-free at the Fed," Bernanke said in a December 7 speech.

Another Reason Why Rates Can't Rise

Peter Eavis, one of the country's top business journalists who writes for the Wall Street Journal, a rate hike could hit banks in unforeseen ways. Eavis cites a study of 24 banks by Goldman Sachs, which found that securities holdings at the banks rose 20% in the year through September. A rate spike would cause sudden losses in those portfolios, Eavis says.

And a rate increase could cause higher defaults on floating rate loans, which have become far easier to pay with rates at historic lows. Since 57% of loans are floating-rate, as per Goldman, that pain would be dramatic, offsetting the higher interest income the banks get on consumer borrowings, Eavis says.

Eavis says Wells Fargo disclosed that profits would take a 5% iht if the fed funds rate rose to 3.75% and the 10 year treasury jumped to 5.9%, up from zero to 0.25% and 3.8% respectively.