This September, the overnight lending market (aka “repo” market) saw its rates mysteriously spike to 10%.
This surge in borrowing costs shocked everyone, as lending rates typically hover around the 2% range.
What it indicated was a dramatic drop in liquidity--a drop so significant that the repo market may have been teetering toward crisis levels.
The Federal Reserve had no choice other than to rescue the repo markets, injecting liquidity worth Billions of dollars to contain a fire that otherwise might have spread into other areas of the financial system.
Such a liquidity drop warranting intervention hadn’t taken place since 2007, the year leading up to the 2008 financial crisis.
But at the end of the third week in September, the Fed brushed off the incident, announcing that it was a temporary imbalance easily resolved through short-term intervention.
That “short-term” intervention hasn’t yet ended, nor does the Fed see an end in the near-term horizon.
Apparently, the temporary problem wasn’t temporary at all.
So, what caused the lending rate to spike? If you browse news items going back to the time when this liquidity crisis had first unfolded, you wouldn’t find a clear answer.
Recently, however, there’s news emerging that points to at least one potential culprit: JPMorgan Chase.
Using Depositor Funds to Repurchase Stocks
Let’s back up a minute and talk about JPMorgan Chase (we’ll shorten it to JPMorgan from here on).
JPMorgan has approximately $1.6 Trillion in deposits and 5,000 branches, making it the largest bank in the US.
It goes without saying that its role in providing liquidity is so massive that various segments of the financial industry rely on the bank’s participation.
Should JPMorgan withdraw that liquidity from the financial system, the consequences on a systemic level would be painful to imagine.
To a certain extent, that’s what happened mid-September.
Looking at JPMorgan’s SEC filings over the last seven years, the bank had repurchased $77 Billion of its own stock. In 2019 alone, JPMorgan had spent $17 Billion in buybacks.
As you are probably aware, buybacks are used to prop up shares of company stock.
What’s a bit concerning, however, is that JPMorgan is using depositor funds to pay for stock repurchases and to cover dividend payments.
Imagine, if you have funds deposited at JPMorgan Chase bank, they used part of your funds to prop up their stock prices and to pay dividends to their investors--good for investors, perhaps, but not necessarily a good thing for depositors, especially considering that many of their depositors may have been unaware of this operation.
JPMorgan’s SEC filing reads:
“In 2019, cash provided resulted from higher deposits and securities loaned or sold under repurchase agreements, partially offset by net payments on long-term borrowing…cash was used for repurchases of common stock and cash dividends on common and preferred stock.”
But hold on--iIsn’t the job of a commercial bank to provide loans to consumers and businesses?
If that’s the case, then a good portion of the $77 Billion that JPMorgan had spent propping up its stock price should have been capital used to provide loans to consumers and businesses.
You can argue against that assumption, but it’s pretty clear that that’s the primary function of a commercial bank.
But here’s another thing to consider: how many other commercial banks have been doing the same thing?
If you factor in the Billions that other financial banks might have held back from the debt markets in order to repurchase stock, then it’s clear why, in mid-September, overnight lending rates spiked due to a severe liquidity shortage.
This, of course, forced the lender of last resort--the Federal Reserve--to step in and provide ongoing liquidity injections.
As an investor, it’s important to bear in mind that the Fed’s artificially low-interest rates are what have enabled massive stock buybacks in the first place.
Perhaps you own banking stocks in your portfolio and you’ve been enjoying the nice run that these buybacks have helped boost over the last decade or so?
So, what might happen when these stock buybacks begin to slow? What might happen when monetary policy tightens, no longer enabling banks to continue their repurchases?
What might happen to the billions of depositor funds used for repurchases should the repo market liquidity crisis spread beyond the overnight lending market?
Bear in mind that the SEC and Federal Reserve have practically enabled these practices along with the risks they entail.
Recently, the Fed announced that it's boosting its repo market “bailout” to $690 Billion a week.
A temporary liquidity crisis? We think not.
Is there a looming financial crisis on the horizon? It depends.
Would you rather err on the side of optimism, or caution?