Earlier, I referred to the repo-market flare-up in September as being like the death-foreshadowing cough in the second reel of a melodrama. In a subsequent interview I did with USA Watchdog’s Greg Hunter, I noted that it was especially curious that, two months after a short-squeeze on bank reserves spiked overnight rates to 10%, the supposed experts had yet to figure out what caused it. It was hardly comforting that more than a few of them attributed the crisis to the banks’ higher-than-usual cash needs at the end of a quarter. This explanation seemed to pass muster at the time, but it was obviously wrong. For in fact, the banks’ cash requirements had been precisely knowable weeks earlier. That’s how the banksters work — how they leverage-to-the-max every dime that falls into their greedy, uncalloused hands. They practice a particularly sophisticated version of just-in-time inventory, calculating duration down-to-the-minute and allocating collateral so that it divides faster than E coli.
Smart guys. The trouble is, such calculations are almost invariably based on business-as-usual. This time, unfortunately, the game changed unexpectedly. In repo transactions, the lender typically holds collateral in the form of cash reserves or Treasurys. But in September the rentiers held an unusually high proportion of Treasury paper, which created a cash shortage in the banking system. Why did they choose Treasurys over dollars? The un-simple answer is that they were eagerly anticipating front-running the Fed’s purchase of Treasurys from the banks. The logic behind this gambit is spelled out in fascinating detail in a think-piece at ZeroHedge. The very troubling insights contained in the article are those of Zoltan Pozsar, arguably the foremost expert in the world on repo markets. Pozsar says that what I’ve called an ominous cough spells potentially big trouble for the banking system. The article is a difficult slog but well worth your time. You will need to understand perhaps 20% of it to get a foreboding sense of what is coming. But even if you understand nothing, keep in mind that a man who knows everything there is to know about how the repo market works says it’s headed for a crack-up. Still worse is that, for reasons that were too complex to have predicted, the Fed may be powerless to re-liquefy system the next time repo borrowers are urgently pressed for cash. Beware, since an unintended stress test could occur before the year ends as banks attempt to square up their books.