On Saturday I noted that details of the FDIC guarantees of fed funds implemented on October 14 could introduce a substantial wedge between the fed funds target and the effective fed funds rate. Rebecca Wilder argues that this could not be affecting the current effective fed funds rate due to details of the “opt out” provision. Here I provide some further discussion of this point.
I believe that Rebecca Wilder is correct that I was misinterpreting the FDIC October 16 technical briefing. A substantially clearer statement appears in the implementation of the interim rule in the October 29 Federal Register:
Beginning on November 13, 2008, any
eligible entity that has not chosen to opt out of the debt guarantee program will
be assessed fees for continued coverage.
All eligible debt issued from October 14,
2008 (and still outstanding on
November 13, 2008), through June 30,
2009, will be charged an annualized fee
equal to 75 basis points multiplied by
the amount of debt issued, and
calculated for the maturity period of
that debt or June 30, 2012, whichever is
earlier. The fee charged will take into
account that no fees will be charged
during the first 30 days of the program.
That seems to state pretty clearly that a bank will not be assessed the 75 basis point fee on overnight fed funds borrowed prior to November 13. Moreover, on November 3 the FDIC extended the deadline for opting out of the program until December 5.
But this brings me back to my original core puzzle. If bank fund managers indeed understand the interim system to be as described, there should be a perfect arbitrage opportunity from borrowing fed funds from the GSEs at a 0.25% rate, holding them as excess reserves on which they are now paid 1.0% by the Fed, and pocketing the difference. Banks trying to take advantage of this should be bidding up the rate for borrowing overnight fed funds above 25 basis points.
If we have among our readers any fund managers who can tell us why you’re not bidding up the price of borrowed funds to profit from this right now, I welcome the opportunity to be educated further.