By Liz Capo McCormick Sept. 22 (Bloomberg) — The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions. Central bank officials are discussing plans to use so- called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That’s where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system. There’s no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank’s challenge is to decrease the cash without stunting the economy’s recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates. “One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten,” said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. “They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb.” Fed Balance Sheet Deborah Kilroe, a spokeswoman for the Federal Reserve Bank of New York, declined to comment about meetings with dealers. Total assets on the Fed’s balance sheet stand at $2.14 trillion, up more than a $1 trillion since the collapse of the subprime mortgage market in August 2007 triggered the worst global financial crisis since the Great Depression. The Federal Open Market Committee, at the conclusion tomorrow of a two-day policy meeting, will probably maintain its assessment that “tight” bank credit is impeding growth, said economists including former Fed Governor Lyle Gramley . The Fed will keep its target rate for overnight loans at a range of zero to 0.25 percent at the conclusion of the FOMC meeting, all 91 economists surveyed by Bloomberg News said. Minutes from FOMC’s Aug. 11-12 meeting showed that among the exit strategy options discussed were reverse repurchase agreements as well as setting up a term deposit facility to reduce the supply of banks’ excess reserves. Repo Sizes At maturity of a reverse repo, the securities the Fed sold to the dealers are returned to the central bank, and the cash goes back to the companies. The reverse repurchase agreements contemplated by the Fed would need to be for a longer period and larger size than has been typical in previous open market operations, according to strategists. “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,” said Joseph Abate, a money market strategist in New York at Barclays Plc, a primary dealer. “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.” Steps taken by the Fed since March 2008 to combat the seizure in credit markets included expanding emergency lending to banks, supporting the commercial-paper market and bailing out New York-based insurer American International Group Inc. “The timing is not now for the exit strategies to begin,” said Tony Crescenzi, a market strategist and portfolio manager at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund. Talk of exit strategies “will all seem very preliminary and conditional upon evidence that the economy is moving toward a self-sustaining and self-reinforcing condition. The proof of that will be some improvement in the labor market picture,” he said. More Participants The jobless rate reached 9.7 percent in August, the highest in a quarter-century. Employers have eliminated almost 7 million jobs since the recession started, the biggest drop in any post- World War II economic decline. Bernanke said in the opinion piece that reverse repos could be done with counterparties beyond the Fed’s primary dealers, which serve as counterparties in open market operations and are required to bid on Treasury auctions. 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. Banks worldwide have recorded more than $1.6 trillion of losses and writedowns since the start of 2007, according to data compiled by Bloomberg. General Collateral Rate Securities dealers use repos to finance holdings and increase leverage. Bonds that can be borrowed at interest rates close to the Fed’s target rate for overnight loans between banks are called general collateral. Those in highest demand have lower rates and are called “special.” As the supply of Treasuries increases, which occurs when reverse repos take place, repurchase agreement rates are typically pushed higher. The rate on collateralized loans in the more than $5-trillion-a-day repurchase agreement market, where Treasuries are borrowed and lent, is already higher than the amount changed for unsecured borrowing of federal funds. The overnight general collateral repurchase rate, which is typically a few basis points below the fed funds rate, opened at 0.20 percent today, compared with fed funds at 0.17 percent, according to GovPX Inc., a unit of ICAP Plc. A basis point is 0.01 percentage point. Wrightson is also part of ICAP. When the Fed does begin, “it will use reverse repos in tandem with other draining operations,” said George Goncalves, chief fixed-income rates strategist in New York at Cantor Fitzgerald LP, a primary dealer. “The Fed won’t want to totally disrupt the repo markets and the short-term financing of Treasuries given how much debt is coming to market.” To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net .
