Why the Federal Reserve Needs a Tighter Leash

I have no problem with the Federal Reserve taking away the punch bowl when the party gets out of hand, but these days, the Federal Reserve spends most of its time bailing out rampant and reckless speculation:

One hurdle to a possible fix for recent volatility in the short-term cash markets: hedge funds.

Federal Reserve officials are considering a new tool to ease stresses in the market for Treasury repurchase agreements, or repos. Through the repo market, banks and hedge funds borrow cash overnight, while pledging safe securities such as government bonds as collateral. In September, an unexpected shortage of available cash to lend sparked a surge in the cost of repo-market borrowing, prompting the Fed to intervene for the first time since the financial crisis.

One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market’s clearinghouse, the Fixed Income Clearing Corp., or FICC.

Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations—repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower’s default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.

The Fed’s aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September’s volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.

Yet the new approach could also create political problems for policy makers, analysts said. The problem centers on the central bank lending directly to hedge funds, the little-regulated investment vehicles that tend to serve wealthy or institutional investors.

The political backlash that followed crisis-era bank rescues hangs over policy makers’ approach to the current problem, analysts said, even as officials work to ensure the smooth functioning of a key piece of the infrastructure underpinning financial markets. Some fear that lending directly to hedge funds could lead to the perception the Fed is fueling risky bets.

“There’s a strong aversion to fat cat bailouts,” said Glenn Havlicek, chief executive of GLMX, which provides technology to repo trading desks.

Many hedge funds trade in the cash market through sponsored repos. The clearinghouse sits between buyers and sellers to ensure that neither party backs out of the transaction. Records of cleared trades also are publicly available, improving the market’s transparency.

The solution is to wind down the Repo market by making it more expensive gradually, which is something that the Fed can do, and it would reduce the risks in the market, but it would also reduce speculative profits, which is antithetical to the Central Bank's true agenda.

Instead, they are looking at refilling the punch bowl, and adding Everclear.

This will not end well.