The Federal Reserve and Financial Repression

Pacific Investment Management Company co-founder Bill Gross is starting to talk about what "financial repression" means for the bond markets, which America has not seen since the darkest days of the 1930's when the term was first used.  I'm starting to talk about what financial repression means for Americans.

The Federal Reserve Bank has eighteen middlemen known as primary dealers.  These are, for the most part, investment banks that have access to the Federal Reserve discount window, which is operated by the Federal Open Markets Committee (FOMC). 

Primary dealers are part of an exclusive club -- they have access to the discount rate (which is near zero), and they supply regional and local banks with cash.  Wells Fargo, Bank of America, Goldman Sachs, Credit Suisse, UBS, and Deutsche Bank are some of the institutions that deal directly with the Fed.  Investment banks are a crucial part of the global financial system, and for the most part, do their jobs honestly and efficiently.

There is no worldwide "banking conspiracy," as some say.  The ECB, the IMF, the World Bank, and others are not "ganging up" on America to bring it down.  However, the central bank in America has added to its balance sheet unprecedented amounts of non-cash assets -- $1.25 trillion in mortgage-backed securities and $1 trillion in treasury securities (from QE1 and QE2).  This $2.4 trillion is clogging up the Federal Reserve's balance sheet and must be moved somewhere when the Fed wraps up its bond-buying program later this month. 

The Federal Reserve has very little real money.  Hence, it has bought these assets by borrowing from the vast reserves on deposit from its member banks (which it can legally do).  The Fed borrows at zero percent and lends at 3%.  This is what's called "borrowing short-term and lending long-term."  The Fed's dilemma is that if interest rates rise, their bond portfolio loses value.  According to an analysis by former Atlanta Fed president William F. Ford, a 1% rise in long-term interest rates would lower the value of the Fed's bond holdings by $100 billion (essentially wiping out its 2010 earnings of $81.7 billion).  Unlike private banks, the Federal Reserve does not adhere to asset-to-capital requirements.  This means that they can be overleveraged indefinitely, as evidenced by the 98-1 leverage ratio, which is astronomical by any banking standard.

It is being speculated in some circles that the undercapitalized Fed will force the broker-dealers into buying chunks of its massive portfolio, effectively taking it off their hands.  This will get it off the books and allow them to buy more in the future if they want to try to keep interest rates low.  The Wall Street Journal's Matt Phillips on May 25 reported on the Fed's exit strategy. 

The Federal Reserve Bank of New York announced it was further broadening the pool of those eligible to take part in reverse-repurchase agreements, expected to be a key tool the Fed will use to exit from the accommodative stance it has been in since the financial crisis hit in 2008.Under the arrangement, the buyers essentially lend cash to the Fed, removing excess reserves from the system.

This is true, except that buyers won't be lending cash to anyone.  The cash will be confiscated.  If it pursues this policy, the Federal Reserve is going to strong-arm the broker-dealers into buying these things, which would be pawned off onto us, the taxpayer.  Here's what the result would look like:

When your local bank is forced into buying treasuries and mortgage-backed securities, it will have to pay for them in cash.  This will create an intractable credit freeze, because banks will have spent the money buying treasuries and other securitized products. 

There would be no cash left in the vaults and no cash left in the drawers.  Without cash reserves, banks would not be able to fund credit card purchases, debit card purchases, or supply ATM machines with dollar bills.  They would not be able to underwrite small business loans either.  There simply wouldn't be any cash available because they will have used it to buy securities.

A dollar bill is credit. If you look at a Federal Reserve note, it says, "This note is legal tender for all debts, public and private."  A private debt is when you hand a dollar to the cashier at McDonald's to buy a cheeseburger.  McDonald's is in debt to you for a brief moment, until you get your burger.  When you get your burger, the debt is repaid.  But without credit, i.e. Federal Reserve notes with the pictures of presidents, nobody can transact business.  Economists refer to these situations as "credit constraints," or a credit freeze.  Stanford University professor Ronald McKinnon puts it in easy-to-understand terms in a May 24 Wall Street Journal Opinion piece: 

Credit lines are open-ended in the sense that the commercial borrower can choose when - and how much - he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines. If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess credit reserves with little of no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus revenues will become loath to part with them for a derisory yield.

What Professor McKinnon is saying is that local banks that service you and me will be cash-poor and asset-rich, i.e. no liquidity.  You can't buy a cheeseburger with a mortgage-backed security.  He adds: 

Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.

Three years after the collapse of Lehman Brothers, there are still an alarming number of banks failing.  What this means is that if this situation continues, there won't be any banks left for you and me.  The types of banks that Professor McKinnon is talking about here are the banks that facilitate credit card purchases, ATM debit purchases, and cash withdrawals.  Instead of long lines at banks and S&L's as we saw during the Great Depression, you'll see a run on ATMs.  Good luck buying gas or groceries if credit cards are denied and ATMs are empty.

Pacific Investment Management Company co-founder Bill Gross is starting to talk about what "financial repression" means for the bond markets, which America has not seen since the darkest days of the 1930's when the term was first used.  I'm starting to talk about what financial repression means for Americans.

The Federal Reserve Bank has eighteen middlemen known as primary dealers.  These are, for the most part, investment banks that have access to the Federal Reserve discount window, which is operated by the Federal Open Markets Committee (FOMC). 

Primary dealers are part of an exclusive club -- they have access to the discount rate (which is near zero), and they supply regional and local banks with cash.  Wells Fargo, Bank of America, Goldman Sachs, Credit Suisse, UBS, and Deutsche Bank are some of the institutions that deal directly with the Fed.  Investment banks are a crucial part of the global financial system, and for the most part, do their jobs honestly and efficiently.

There is no worldwide "banking conspiracy," as some say.  The ECB, the IMF, the World Bank, and others are not "ganging up" on America to bring it down.  However, the central bank in America has added to its balance sheet unprecedented amounts of non-cash assets -- $1.25 trillion in mortgage-backed securities and $1 trillion in treasury securities (from QE1 and QE2).  This $2.4 trillion is clogging up the Federal Reserve's balance sheet and must be moved somewhere when the Fed wraps up its bond-buying program later this month. 

The Federal Reserve has very little real money.  Hence, it has bought these assets by borrowing from the vast reserves on deposit from its member banks (which it can legally do).  The Fed borrows at zero percent and lends at 3%.  This is what's called "borrowing short-term and lending long-term."  The Fed's dilemma is that if interest rates rise, their bond portfolio loses value.  According to an analysis by former Atlanta Fed president William F. Ford, a 1% rise in long-term interest rates would lower the value of the Fed's bond holdings by $100 billion (essentially wiping out its 2010 earnings of $81.7 billion).  Unlike private banks, the Federal Reserve does not adhere to asset-to-capital requirements.  This means that they can be overleveraged indefinitely, as evidenced by the 98-1 leverage ratio, which is astronomical by any banking standard.

It is being speculated in some circles that the undercapitalized Fed will force the broker-dealers into buying chunks of its massive portfolio, effectively taking it off their hands.  This will get it off the books and allow them to buy more in the future if they want to try to keep interest rates low.  The Wall Street Journal's Matt Phillips on May 25 reported on the Fed's exit strategy. 

The Federal Reserve Bank of New York announced it was further broadening the pool of those eligible to take part in reverse-repurchase agreements, expected to be a key tool the Fed will use to exit from the accommodative stance it has been in since the financial crisis hit in 2008.Under the arrangement, the buyers essentially lend cash to the Fed, removing excess reserves from the system.

This is true, except that buyers won't be lending cash to anyone.  The cash will be confiscated.  If it pursues this policy, the Federal Reserve is going to strong-arm the broker-dealers into buying these things, which would be pawned off onto us, the taxpayer.  Here's what the result would look like:

When your local bank is forced into buying treasuries and mortgage-backed securities, it will have to pay for them in cash.  This will create an intractable credit freeze, because banks will have spent the money buying treasuries and other securitized products. 

There would be no cash left in the vaults and no cash left in the drawers.  Without cash reserves, banks would not be able to fund credit card purchases, debit card purchases, or supply ATM machines with dollar bills.  They would not be able to underwrite small business loans either.  There simply wouldn't be any cash available because they will have used it to buy securities.

A dollar bill is credit. If you look at a Federal Reserve note, it says, "This note is legal tender for all debts, public and private."  A private debt is when you hand a dollar to the cashier at McDonald's to buy a cheeseburger.  McDonald's is in debt to you for a brief moment, until you get your burger.  When you get your burger, the debt is repaid.  But without credit, i.e. Federal Reserve notes with the pictures of presidents, nobody can transact business.  Economists refer to these situations as "credit constraints," or a credit freeze.  Stanford University professor Ronald McKinnon puts it in easy-to-understand terms in a May 24 Wall Street Journal Opinion piece: 

Credit lines are open-ended in the sense that the commercial borrower can choose when - and how much - he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines. If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess credit reserves with little of no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus revenues will become loath to part with them for a derisory yield.

What Professor McKinnon is saying is that local banks that service you and me will be cash-poor and asset-rich, i.e. no liquidity.  You can't buy a cheeseburger with a mortgage-backed security.  He adds: 

Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.

Three years after the collapse of Lehman Brothers, there are still an alarming number of banks failing.  What this means is that if this situation continues, there won't be any banks left for you and me.  The types of banks that Professor McKinnon is talking about here are the banks that facilitate credit card purchases, ATM debit purchases, and cash withdrawals.  Instead of long lines at banks and S&L's as we saw during the Great Depression, you'll see a run on ATMs.  Good luck buying gas or groceries if credit cards are denied and ATMs are empty.