The Banks Newest Sweetheart Deal

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The Banks Newest Sweetheart Deal

by Michael S. Rozeff

On Dec. 28, 2009, the Federal Reserve (FED) released itsproposal to pay interest to banks on

term deposits. At present, the FED pays interest on bank reserves (both required and excess) at arate of 0.25 percent. With the incentive of higher short-term rates to be paid on term deposits,

banks, when this proposal becomes effective, can convert their reserves into term deposits, at

what will be a higher rate of interest. The rates will be determined by an auction procedure with a

maximum allowable rate to be paid. The funds in term deposits will no longer be available as

reserves or to make payments over the life of the deposit. However, they will be usable as

collateral if banks wish to borrow against them at the discount rate (currently 0.50 to 1.00

percent.)

This proposal has been in the making for awhile. It cropped up earlier in the notion of Federal

Reserve bonds, discussed here a year ago. It is billed as part of the FEDs exit strategy (from its

balance sheet expansion), but its really a strategy of controlling that balance sheet, not reducingit. Its a strategy of consolidating the FEDs enlarged role. Its also a strategy of influencing the

perceptions of market participants so that they do not thwart the FEDs actions by driving up

interest rates, fleeing from the dollar, or moving heavily into gold.

When this proposal is implemented, as it will, the FED will use it to sterilize an unknown portion

of excess reserves, now present in the amount of $1.077 trillion. Sterilization means that the term

deposits at the FED no longer can enter into a multiple deposit expansion process in the banking

system. (They will still be the result of a one-for-one deposit expansion.) The amount sterilized

will depend on how large an amount that the FED offers to banks on an auction basis and how

much they buy.

The sterilization can only be achieved using this technique through continuing and repetitive

auctions. Through this method, the FED can control bank reserves without buying and selling

securities. It can buy time to sell off its oversized portfolio of mortgage-backed securities,

although only token sales are likely in an attempt to manage market expectations. It can expand

bank reserves by offering fewer deposits for sale, or it can contract them by offering more.

The reason for this proposal, according to the FED, is that it has supplied an unprecedentedvolume of reserves to the banking system. The latter is true. The FED enormously inflated the

monetary base, providing the banks with the wherewithal to expand the money supply by an order of

magnitude. The FEDs announcement says Term deposits could be part of the Federal Reservestool kit to drain reserves... This is not entirely accurate. The term deposits will have rather short

maturities of 16 weeks or less. They neutralize reserves temporarily at a price that must be paid on

an ongoingbasis. They do not remove them or drain them in a permanent or even semi-permanent

sense. That can only be done if the FED sells securities outright that it now holds as assets.

A number of things are associated with this proposal, of which I will mention five to begin with.

(1) In the past year or so, the FED supplied the U.S. government with vast credit. It included

$300 billion to the U.S. Treasury and another $1.2 trillion for mortgage-related securities of
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Fannie Mae and Freddie Mac, now under government control. (2) In the process, it brought

yields down on these securities. This has distorted both capital and credit markets by holding up

asset prices. (3) The FED engaged in fiscal policy by directly exercising a one-sided preference to

support housing markets. (4) Due to the nature of the U.S. monetary system, these FED

purchases of U.S. securities more than doubled the monetary base (currency plus bank reserves.)

Since bank reserves are convertible into currency, the FED vastly inflated the supply of non-interest bearing Federal Reserve notes or dollars. This has prevented prices of consumer goods

and services from declining. (5) The FEDs purchases helped prevent insolvent banks from

failing.

The FEDs excess earnings from the securities it buys, beyond its operational requirements,

ordinarily go to the U.S. Treasury. But if the FED pays 1 percent interest on $1 trillion of term

deposits, the U.S. Treasury receives $10 billion less. In other words, taxpayers pay the banks $10

billion a yearnotto make loans to the public but instead to buy the FEDs term deposits. This

risk-free investment has a present value to the banks of $1 trillion if continued forever

(discounting the future cash flows at 1 percent and neglecting taxes that the banks pay.) This is a

massive sweetheart deal in which the U.S. government transfers taxpayer wealth to the banks.This is a sixth outcome of the FEDs actions that is about to occur. It is fitting that the FED

announced this Christmas present on Dec. 28. The taxpayers are being forced to play Santa Claus

to the banks. This is a hidden bailout that has received no publicity.

Long-term yields are now starting to rise. The banks are starting to have a greater incentive to

buy the mortgage-backed securities from the FED or help finance others to buy them. But the

FED will lose money whether they sell them or not, due to the rise in yields. This will lower its

capital. The loss will be felt in the higher risk and lower value of the FEDs notes (the dollar), if

it has not already been felt. This is a seventh effect of the FEDs aid to Fannie and Freddie.

In the past two years, the FED has moved more and more into the fold of the U.S. Treasury or thegovernment. FED independence has never been all that much present, but what degree there was

has gone down even further by its massive subsidization of home loans and now by sterilizing

bank reserves.

The FED and the government are acting somewhat like the American colonial land bank system

of the 1700s. But todays monetary system is actually worse than the colonial land banks in

important respects. The colonial land banks were operated by colonial government loan offices

that issued paper currency against sufficient collateral, normally real estate with a market value

at least twice the size of the loan, according to historian Edwin J. Perkins in his book (p. 70)

American Public Finance and Financial Services, 1700-1815. This was true of some, not all the

colonies. In any event, todays ratios of value to the loan are far lower. The colonial system was

decentralized down to the state and local levels. In New England, local town boards made the

loans. In New Jersey and New York, it was county boards. Because of this, the lenders knew the

borrowers. The current system of lender mortgage origination followed by resale to government

agencies has undermined the connection between borrower and lender at the local level. Colonial

legislatures promised to redeem their bills of credit, while FED notes are irredeemable. Colonial

currencies competed with each other; they were not monopoly issues like the FEDs. Loan terms


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of maturity were shorter than todays. The colonial currencies were notusually legal tender. The

other major difference between then and now is that colonial debt was far lower. The FED-

government nexus today is much less constrained in fostering a debt-laden system than were the

colonial legislatures of yesteryear.

In some respects, little has changed in 300 years. The colonial currencies depreciated, just asFED notes have depreciated.

But one thing that the colonial system could not have had and didnt have was a sweetheart deal

by which banks received taxpayer funds fornotmaking loans. Legislatures usually went easy on

borrowers who were overdue on payments. The vast majority of borrowers were ordinary

farmers, mechanics, and people who had trades. The taxpayer money that legislatures gave up by

shoddy collection practices largely found its way into the hands of taxpayers acting as borrowers.

It was not siphoned off into the coffers of banks.

The FED can succeed in sterilizing bank reserves. Taxpayers will foot the bill, for if Congress

insisted on receiving all the interest income from the FEDs securities, the FED would be unableto pay the necessary interest to banks without impairing the dollar. Once the FED gets used to the

new procedures, the door will be open to more quantitative easing, i.e., new credit creation

directed to the U.S. government. The government credit bubble can be blown up further with the

FEDs assistance because the FED will have a tool to neutralize the resulting reserves. The

government, actually taxpayers, will be paying the banks more and more money for doing

nothing.

With the use of this tool, U.S. government control over the American economy takes a giant step

forward. If a power like this is pushed to the limit, what happens? When the FED sterilizes bank

reserves and directs credit to the government and its favored enterprises, the government can

distribute funds to any projects that it favors. It can bypass banks entirely, or it can see to it thatthe FED provides them with enough reserves to lend to areas that it favors. America then moves

further into a government-managed economy. Such an economy has fewer and fewer projects

that create wealth and well-being, and more and more projects that lose money or destroy wealth

and well-being. The economys ability to generate returns on invested capital declines, which

spells low returns for a host of securities. Eventually, perhaps years from now, a battle will erupt

within government about paying off banks for doing nothing. The banking lobby will want to

continue the subsidy. Its opponents will want to absorb the banking system entirely.

What will happen to the dollar if the FEDs power to neutralize reserves becomes habitual? The

government will target more and more dollars to unproductive purposes, as it has done with

housing and a few other selected areas like AIG and autos, and as it is doing with energy. The

FED will supply those dollars, and the result will be that the dollar declines in value. For

example, the Obama administration already has removed limits on providing taxpayer funds to

Fannie and Freddie. GMAC has its hand out for more. As the economy becomes more and more

government-managed, the currency becomes less and less suitable for international commercial

transactions as its value is questioned and as the economy becomes less and less important within

the world economy. In the Soviet Union, there was an official currency conversion rate and a


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black market rate that more accurately reflected the centralized economic control.

These are economic possibilities, on the horizon but drawing ever closer, that the FEDs recent

actions portend. The U.S. economy is moving into a qualitatively different structure in which

centralized management plays a larger role than ever. A popular or populist-oriented third party

movement among Americans that resists this tendency might conceivably cause one of the majorparties to alter course in order to gain power, in which case the centralizing tendency might be

slowed or aborted. However, the fact of the matter is that America has been proceeding in the

opposite direction for a very long time. Centralization speeded up in the last few years.

For the present, the banks have a sweetheart deal. Their long-run picture within an increasingly

controlled and centralized economy is not so sanguine. Neither is that of the American economy

and the American people.

Michael Rozeff is a retired professor of finance. An archive of his articles appears here. Other of

his articles may be found here. His technical finance papers are available at SSRN.

All of Prof. Rozeffs essays, including the work above, contain information, data, opinions,

judgments, hypotheses, theories, ideas, and conclusions that are tentative, subject to revision, and

subject to error. They are written and published in order to focus his own thinking, to stimulate

the thinking of others, and as a public service. They are not written as investment advice or as a

reliable basis for making investment decisions. Prof. Rozeff is not in the investment advisory

business in any capacity and provides no investment advice. He has no responsibility for any

investment decisions that readers may base upon his writings or for any losses that may result as

a consequence of reliance upon or interpretation of his writing. As speculating and investing

involve risk of loss,.he advises readers strongly to seek out professional advice from professional

investment advisors and/or to make their own investment decisions after due diligence and

research that comprehend a variety of sources. Prof. Rozeff may have a long or short position insecurities or markets that he mentions.

January 2, 2010
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The Banks Newest Sweetheart Deal