Fed, Bank, Treasury - Magic Money Machine?

[skurla2000]

I posted this theory on another thread but wanted to try to bring it to the attention of the most intelligent iTulipers and possibly EJ or FRED.

I need the help of SMART people...

In response to the huge news query today "where did the TARP bank money go", I have theorized that it... and the explosion of FED lending facility money, has gone to create a great free magic money machine for the US Treasury.

I believe that the majority of money being directed to banks through the various Fed windows and the TARP, is being used to purchase Treasury notes.

By using fractional reserves, banks can buy 10x what they receive for free or borrow at 0%, earning up to maybe 20% on every dollar they can bring in the door.

This benefits the bank, as the income from these investments can keep them afloat, even with dwindling deposits and virtually no loan activity.

It also benefits the Treasury, who can receive in cash 10x the amount of money that the Fed loans, fixed short and long term at attractive rates.

So it basically goes like this:

a) $1 borrowed from Fed at 0% or received from TARP
b) $1 turns into $10 loaned to Treasury at 2%
c) 200% bank profit on the borrowed $1
d) $9 created out of thin air for the Treasury
e) No need to "print" money

As a bonus, using this system, banks don't need customers anymore, and the government doesn't even need taxpayers!

I realize I don't have a news story or hard evidence for this, but can anyone tell me why this would or wouldn't work and how we can know for sure? It sure would explain the huge explosion in Fed facility lending AND the T-Bill Bubble...

Thanks in advance...

[Sharky]

Re: Fed, Bank, Treasury - Magic Money Machine?

First of all, banks can't loan themselves money, so the leveraged scenario you suggest wouldn't work.

To understand what the banks are doing with TAF and TARP money, you need to know about Bank Reserves.

Reserves are a special type of money that can only be created by the Fed. Reserves are created when the Fed buys Treasuries from the public, and they are destroyed when the Fed sells Treasuries to the public. That's the mechanism that the FOMC uses to influence the Fed Funds rate. Reserves can also be borrowed from the Fed via the Discount Window. The purchase and sale of Treasuries among private parties does not influence Bank Reserves. One key point here is that Treasuries and Reserves are not the same thing, and are in one sense actually opposites of each other.

Reserves are important because they form the foundation of the banking system. Banks are only allowed to lend up to some multiple of the reserves they hold.

When a bank creates a new loan, they don't lend out reserves. Instead, they create new money ("credit money") just for that purpose. When a loan is repaid, the credit money is destroyed. However, what happens if a loan defaults? The bank has to absorb that loss. It does so by writing the loan off against its balance sheet. However -- and this is key -- the result is the destruction of bank reserves. The original credit money is still loose in the economy (the borrower presumably spent it; buying a house for example), and can't be reclaimed. The only other source of funds is reserves. So a bank operating with a 12% reserve ratio that suddenly has 3% loan defaults now has a 9% reserve ratio and is forced by the regulators to close its doors or merge with a larger bank, since it has fallen below the 10% limit.

So the goal of the TAF and similar follow-on programs was first and foremost to replenish bank reserves. Banks were allowed to put up (bad) collateral and get reserves in exchange -- like what they could do with the Discount Window before, but in a streamlined way and at more favorable rates.

So, with that background, why would a bank want to buy Treasuries? Banks can only buy them with reserves, not with credit money, since banks aren't allowed to create new money for themselves (they can't loan themselves money). But if they're running short of reserves, that could easily be suicidal. Before Oct 2008 or so, that might have made sense for excess reserves, since they didn't used to earn interest. But now the Fed pays interest on all reserves, including excess. The Fed has a whole program that allows banks to optimize their reserves -- that's what the Fed Funds rate is: the rate at which banks loan reserves to one another.

[Spartacus]

Re: Fed, Bank, Treasury - Magic Money Machine?

My reading of this article (which is famous hereabouts, and a conclusion BART seemed to have reached independently)

http://itulip.com/forums/showthread.php?p=8809#poststop

is that reserves and reserve ratios don't really work that way anymore. Sweeps were one technique of de-coupling the monetary bases from the money supply. I used to follow numbers like the AMB until I found out about this stuff. The transmission that hooked up the monetary bases to the banking system has been allowed to be unhitched for some time.

The US FED stopped targeting the total amount of money at some point and decided to peg the interest rate, and either supply or drain the (unspecified) amount of money required to maintain that rate.

US banks could lend almost any amount of money consistent with the US FED's rate regime - theoretically infinite money, with only a tenuous connection to any reserve or any ratio.

Off balance sheet SIVs (also extensively detailed on iTulip) temprarily ruined this concept (of reserve ratios) even further. We don't know for sure yet if the new accounting rules have remedied the situation, or whether there will be new game-playing with the new rules.

The implicit system of leverage operating in the derivatives markets (also extensively detailed on iTulip - see, for examples, EJ's articles analogizing the financial markets to a multiple lane highway) temporarily ruined this concept (of reserve ratios) even further. We don't know for sure yet if the new accounting rules, with their levels of price discovery have remedied the situation, or whether there will be new game-playing with the new rules.

Banks are only allowed to lend up to some multiple of the reserves they hold.

...

So a bank operating with a 12% reserve ratio that suddenly has 3% loan defaults now has a 9% reserve ratio and is forced by the regulators to close its doors or merge with a larger bank, since it has fallen below the 10% limit.

Technically, the defaulting loans and their effects on bank lending and reserves don't themselves seem to be the major issue at the moment.

The problem is in the (previously) inflated values of the derivatives based on the loans, and the current (much reduced) values of the derivatives (see note above about the massive implicit leverage system operating within the world of derivatives).

[Sharky]

Re: Fed, Bank, Treasury - Magic Money Machine?

reserves and reserve ratios don't really work that way anymore. Sweeps were one technique of de-coupling the monetary bases from the money supply.

Ah, very cool that you would call me on that. I'm new to itulip, and most other sites I post at wouldn't even have any idea what I was talking about.

Yes, it's certainly true that reserve requirements aren't as simple as I described. However, the effect of sweeps is only to reduce required reserves, not to eliminate them. Sweeps basically move money from current accounts, which require reserves, into savings accounts, which don't. The net result is to increase bank earnings, since reserves don't earn interest and more loans can be created from non-current account funds. I believe that sweeps are the main reason the Fed hasn't tweaked reserve requirements as part of their "management" of the financial crisis.

But, reserve requirements still exist. And bad loans still destroy reserves. And when reserves get too low, a bank's ability to function is impaired.

To add to the confusion, as of a few months ago, the Fed now pays interest on reserves, apparently including vault cash. This should reduce the pressure banks used to feel to tightly manage reserves on the income side -- but I could also imagine it backfiring, since banks might also be less inclined to loan excess reserves to other banks through the Fed Funds program. Why take on the risk of a loan, when you don't need to? That could in turn decrease stability at some banks if they can't borrow from the Discount Window or from TAF or TARP because they don't have appropriate high-grade collateral.

Also, if banks are disinclined to lend reserves, that will drive the Fed Funds rate up, which will in turn cause the Fed to inject more liquidity into the economy (by buying more Treasuries) -- so it seems inherently inflationary, although I suspect that's by design.

[phirang]

Re: Fed, Bank, Treasury - Magic Money Machine?

sharky, I like how you think.

[Spartacus]

Re: Fed, Bank, Treasury - Magic Money Machine?

reserve requirements do exist but IMHO they are not the cause of the current problems.

I don't know if there is any legal or accounting difference but I've been thinking

1. bad loans reduce profit, not necessarily reduce reserve
2. bad loans increase the requirements for loan loss provisions - THIS is what reduces reserves.

I don't know how bank accounting separates these 2 pools of money, if at all.

And remember, only a small fraction of outstanding mortgages have defaulted. Capital impairment from actual loan losses is still small. It's not the reserve ratio requirements that are forcing banks to stop lending - all the commentary I've seen is that banks are not lending because of risk aversion, NOT because reserves have fallen below reserve ratio requirements

Bernanke and Paulson have both claimed banks could lend again with the amount of money that's been poured into them - Bair was talking about passing legislation to force banks to lend. All those comments also make me think the problem currently is not reserve ratios.

Again, this is all IMHO ... I'm the first to admit this thesis is a work in progress.

But, reserve requirements still exist. And bad loans still destroy reserves. And when reserves get too low, a bank's ability to function is impaired.

Also, if banks are disinclined to lend reserves, that will drive the Fed Funds rate up, which will in turn cause the Fed to inject more liquidity into the economy (by buying more Treasuries) -- so it seems inherently inflationary, although I suspect that's by design.