Sense on Cents

from the guys who made shorting banks illegal —

…..comes the new penalties that make shorting US Treasuries far more expensive …………… the unintended consequence will be a far smaller short book by investors leading to massively higher levels of volatility in bond yields ……. Bernanke will employ any tactic in his quest to manipulate the markets ……. this guy truly begins to scare me at what steps he will take and why i actually believe Lewis that Bernanke threatened him to close on MER ‘or else’

Repo Failure Remedy Drives Away Short-Sellers in Treasuries
2009-04-30 04:00:01.2 GMT

By Liz Capo McCormick
April 30 (Bloomberg) — Just as Federal Reserve Chairman
Ben S. Bernanke revives credit markets, one of his remedies
may reduce trading in Treasuries.
A Fed-endorsed industry recommendation will require
traders to pay a three-percentage-point penalty on
uncompleted trades, known as fails, starting tomorrow. That
may reduce the number of bets on price declines, according
to RBS Securities Inc. and Societe Generale SA.
While the new recommendations are meant to curb disruptions
caused when traders fail to meet their obligations, some
strategists are concerned it may do more harm than good in the
$7 trillion-a-day repurchase market, where dealers finance their
holdings. A reduction in trading would be a setback for the Fed
as it seeks to lower borrowing costs by pumping cash into the
banking system and purchasing as much as $1.75 trillion in
Treasuries and mortgage securities.
“Making short-selling potentially costly can reduce market
liquidity,” said Darrell Duffie, a Stanford University finance
professor and member of the New York Fed’s Financial Advisory
Roundtable. “Financial markets with relatively unencumbered
short-selling perform better.”
The U.S. needs to raise $3.25 trillion this fiscal year to
finances bank bailouts, stimulate the economy and service a
deficit, according to New York-based Goldman Sachs Group Inc.,
one of the 16 primary dealers that trade with the Fed.

Trading Decline

Trading is already down, with volume done through the
primary dealers averaging $363.6 billion a day this year,
compared with $655.6 billion in the same period of 2008 and
$533.3 billion in 2007, according to Fed data.
Interest rates near record lows and surging demand for the
safety of Treasuries pushed the amount of bad trades to a record
$5.3 trillion in the week ended Oct. 22.
Federal Reserve Bank of New York President William Dudley,
who succeeded Geithner in January, said during a Nov. 12
interview that U.S. borrowing costs could rise if the logjam in
the repo market, which dealers use to finance their holdings,
wasn’t rectified. The New York Fed said Jan. 15 that it endorsed
the Treasury Market Practices Group penalty recommendation, as
well as other measures to reduce fails.
The penalty proposed by the TMPG, an industry committee
formed by the Fed in 2007, would add an incremental cost of
$833.33 dollars per day on a failure of $10 million worth of
bonds, according to data compiled by Bloomberg.

Securities as Collateral

In a repurchase agreement, one party provides securities as
collateral to another in exchange for cash. The penalty would
result in the lender receiving a reduced amount when it delivers
the Treasury late.
“Where market makers may have felt comfortable in the past
making outright short sales to investors, there certainly has to
be a greater consideration of these negative costs,” said Ken
Silliman, a Treasury bill trader in Greenwich, Connecticut, at
RBS Securities Inc., another primary dealer. “The fails penalty
has risk of reducing liquidity in bills and Treasuries all along
the yield curve.”
Investor confidence in financial markets is returning after
the U.S. government and the Fed agreed to spend, lend or commit
$12.8 trillion to end the longest recession since the Great
Depression. The London interbank offered rate, or Libor, for
three-month loans in dollars fell yesterday to 1.03 percent, the
lowest level since June 2003, according to the British Bankers’
Association.

Target Rate

Yesterday, the Fed refrained from increasing purchases of
Treasuries and mortgage securities, signaling the worst of the
recession may be over, as it kept the federal funds rate target
at a range of zero to 0.25 percent for the third straight
meeting.
There is little incentive to make good on delivery
commitments when rates are close to zero because the main cost
for failing to deliver a borrowed security is the loss of
interest that would have been received on the money lent to
obtain it.
Overnight general collateral repo rates were about 0.20
percent yesterday, according to GovPX Inc., a unit of ICAP Plc,
the world’s largest inter-dealer broker.
“If you have fails, then the market isn’t functioning
properly,” said Eric Liverance, head of derivatives strategy at
UBS AG in Stamford, Connecticut, another primary dealer. “That
is what we saw last fall when we had massive fails. If you can
lend a bond out and count on it coming back the next day, then
those are properly functioning markets and it enhances
liquidity.”

Going Long

Trading failures fell to as low as $81.06 billion in the
week ended April 8, before rising to $272.4 billion the
following week, according to New York Fed data.
Primary dealers typically short Treasuries as a trading
strategy to hedge their holdings in other securities. That’s
changed this year, leaving them “long,” in part, because of
the new repo recommendations. They held $75.1 billion of
Treasuries as of April 8, the most since at least 1997, compared
with an average of minus $60.6 billion, Bloomberg data show. The
amount fell to $60.6 billion as of April 15.
“That is telling you that dealers really don’t know what
all this will mean,” said Donald Galante, chief investment
officer and senior vice president of fixed income at MF Global
Ltd. in New York. “People are being prudent and saying I am not
going to have a Treasury short now and I’ll wait to see how this
pans out over the next two months.”
Galante advised his traders to not take short positions in
the repo market or in short-term Treasuries going into May to
allow time to analyze how the penalty and movements in repo
rates evolve.

Below Zero

The threat of penalty will likely cause repo rates to drop
below zero on Treasuries that have had high levels of fails or
whose rates have traded close to zero in the repo market,
according to Ira Jersey, head of U.S. interest-rate strategy in
New York at RBC Capital Markets. Jersey cited the current five-
year note as an example. The repo rate on that security was 0.05
percent yesterday, according to GovPX.
A negative repo rate means that investors who lend cash in
exchange for obtaining securities as collateral actually pays
interest instead of receiving it on the money they loan.
Penalties for uncompleted trades will begin to accrue May
1. The due date for filing claims for fails to counterparties in
trades that occur in May will be June 12, and payment or claim
rejections will be due on June 30. In subsequent months the
filing date will coincide with the 10th business day and the
payment date will be on the last business day of the following
month.

‘State of Anxiety’

Because the penalties will be imposed across the government
debt market, unregulated investors such as hedge funds will be
held to the same standard as banks and bond dealers. Since it’s
a recommendation, some dealers are still uncertain which
counterparties will need to pay the penalty.
“The market’s heightened state of anxiety looks likely to
produce unintended and unfortunate consequences,” said Ciaran
O’Hagan, the Paris-based head of fixed-income at Societe
Generale. “The fails penalty adds to the security of the market
at the cost of liquidity. All this suggests that liquidity will
be hurt across the board for U.S. Treasuries.”