A Finance Primer 2

Previously we learned what securities were: financial instruments designed to swap debt all over the place (we’ll ignore ownership for now). Basically, they’re just IOUs.

The financial “industry” consists of trading and gambling with these securities. For every financial transaction, there are parties and counterparties. Like the tango, it takes two.

As I mentioned, banks and other financial institutions loan to each other all the time. This turns out to be quite important. I want to outline a little more of the financial system using that concept.

THE FED FUNDS RATE AND REPO MARKET

As I said above, financial institutions such as banks lend to, and borrow from, each other. But they don’t do it the way they lend to and borrow from you and me. They buy and sell IOUs.

If you deposit $100 and then return a month later to take out your $100, it’s not the exact same $100 you deposited. When you give the bank your money, they invest it and the money they give you is the money they’ve made. Banks are trying to make money from their deposits just like everyone else, so that’s why they loan it out to other institutions. One place where they do so called the financial repo market. This is basically banks loaning to other banks.

Recall that banks have a reserve requirement, which is the ratio of deposit liabilities (what the bank owes its customers) to loanable money.

If a bank has more reserves at the central bank than they need, they loan it out to other banks who may be short. This is done through what are called repurchase agreements, which is where the term “repo” comes from.

So if Bank A has an additional $50m at the end of Thursday, and Bank B needs to get $50m on its books to comply with regulations, Bank A will loan out their extra $50m for an agreed interest rate, and will repurchase the loan on Friday morning. Hence repurchase agreements.

The way this is done is by selling securities. In the above example, Bank B sells Bank A securities in exchange for cash. It agrees to buy back the securities from Bank A at a later date at an agreed-upon (usually higher) price.

Example: Transition Borrower sells government bond worth $100 to lender for $100 cash Borrower agrees to buy back bond for $101 in 1 year 1 year later… Borrower buys bond back for $101, lender receives $101.

So what happened here? Changing the verbiage to what makes more intuitive sense, the borrower gave a lender an asset in exchange for $100 cash. 1 year later the borrower paid back the initial amount ($100) plus an extra amount that they had previously agreed upon ($1) and got the asset back.

Repo Rate (for 1 year repo) = (Final Price-Initial Price)/Initial Price so in this case we see the Repo rate is 1%.

ELI5: What is the repo rate? (Reddit)

Recall that Treasury securities is basically another word for the government’s debt; i.e. the “national debt.” The same national debt that you hear all the scary stories about. Turns out that the debt is necessary for the financial system to function–something the horror stories never manage to tell you. Having no national debt would actually be a problem. Banks are, in fact, actually required to hold a certain amount of U.S. debt in the form of treasury securities.

If the U.S. paid off its debt there would be no more U.S. Treasury bonds in the world…The U.S. borrows money by selling bonds. So the end of debt would mean the end of Treasury bonds.

But the U.S. has been issuing bonds for so long, and the bonds are seen as so safe, that much of the world has come to depend on them. The U.S. Treasury bond is a pillar of the global economy.

Banks buy hundreds of billions of dollars’ worth, because they’re a safe place to park money. Mortgage rates are tied to the interest rate on U.S. treasury bonds.The Federal Reserve — our central bank — buys and sells Treasury bonds all the time, in an effort to keep the economy on track.

If Treasury bonds disappeared, would the world unravel? Would it adjust somehow?

What If We Paid Off The Debt? The Secret Government Report (NPR)

The agreed interest rate that banks charge each other for 1 day loans is called the Fed Funds Rate. The interest rate banks lend to each other obviously affects the rate at which banks lend to you. That’s why it’s extremely important to the financial system as a whole. It sets many of the other domestic interest rates in a sort of domino effect.

The federal funds rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis (or slightly longer). Reserves are excess balances held at the Federal Reserve to maintain reserve requirements. The rate is primarily determined by the balance of supply and demand for the funds.

[The Fed Funds Rate] is just about the most fundamental metric in the entire financial system. Everything from government bonds, to commercial loans, to your mortgage is influenced by how much banks have to pay to square their books at the end of the day.

ELI5: What exactly is the financial repo market? (Reddit)

If there is not enough cash in the system, the Fed Funds rate will increase, affecting the entire system. If the rate is being affected not by market fundamentals, but by some sort of financial crisis for instance, more money is injected via the Federal Reserve to try and bring the rate down.

The Fed Funds rate…is not strictly controlled by the Federal Reserve, but is a market effect that’s a result of Fed actions. Specifically, the Fed buys or sells bonds. If the Fed buys bonds there is more cash in the economy (which means in bank coffers) and fewer interest-paying bonds. This makes rates go down because money supply is higher and banks need to entice someone to borrow it. Inversely, if the Fed sells bonds it pulls cash out of the economy and can make rates higher…Buying or selling bonds a little at a time lets the market naturally adjust the rate to where they want it.

Why does the Fed raise interested [sic] rates (Reddit)

If banks need to borrow money directly from the Fed itself, this is called the discount window, for reasons I’m not entirely sure of, except to make this more complicated and obscure. The Fed is just the national bank, and the interest rate banks pay to borrow from the Fed is called the discount rate. This rate is determined by the Fed. When the Fed wants to inject more money into the system, they lower the discount rate so banks can borrow more money.

Money is a commodity, and it’s “price” is the interest rate. So the Fed doesn’t “declare” an interest rate. It sets a target interest rate, and then buys or sells bonds in order to achieve that interest rate.

We said last time that bonds (IOUs) are a way of “locking up” money for a while. You can imagine dollars being removed temporarily from society like prisoners sitting behind bars in a jail cell if you like. The length of time the bond is for (term) is the “sentence” for the money locked away in the bond. By the time the bond “gets out of jail,” it has had a baby called interest. How many “babies” it has had is determined by the amount of time it has been locked up for.

Selling treasury bonds takes cash *out* of the system (because people pay cash for the bonds.) Selling bonds puts cash back *into* the system (because the bonds are redeemed in cash). Sometimes, of course, the bond is not redeemed for cash, it is simply “rolled over”–one IOU is exchanged for another IOU–in which case cash is not injected back into the system.

The removal and injecting of cash into the system influences the amount of overall money in the system, which consequently determines the interest rate–the price for money. The rate the banks lend to each other helps determine the rate at which they lend to you and everyone else.

Peter Conti-Brown describes the process:

The [Federal Open Markets Committee], in its eight annual meetings, establishes the target federal funds rate, or the rate it wishes to see in the markets for these interbank, short-term loans.

To reach this target, the Fed buys or sells securities on the open market, through the trading desk at the Federal Reserve Bank of New York. Here’s the connection to the federal government: the New York Fed’s primary conventional tool to accomplish the FOMC’s objectives is the purchase and sale of short-term government securities.

When the FOMC decides to raise interest rates, the New York Fed pulls cash out of the financial system by selling the short-term government debt securities the Fed keeps on its books; when the FOMC decides to lower interest rates, the New York Fed injects cash into the finacial system by buying those securities back from the market participants.

When the Fed buys a Treasury security on the open market, it provides the bank on the other side of the transaction with cash–an electronic modification to the bank’s balance sheet. This purchase removes the security from the bank’s balance sheet, and replaces it with greater reserves in the bank’s account at its local Federal Reserve Bank.

In this way, the Fed has expanded the money supply by removing from the banking system an asset that that is harder to sell on the market–a government bond or, more recently, a mortgage backed security–and replacing it with cash, literally Federal Reserve Notes (mostly electronic, of course). These notes are easier assets to use to exchange for other goods and services. Indeed, as the notes themselves report, they are “legal tender for all debts public and private.” In the monetary metaphor, cash is the most “liquid” of assets.

The Fed regulates how much cash banks must keep in their reserves, which are deposited at the bank’s regional Fed. If the bank already has the requisite level of reserves required by the Fed, the cash that is added to its balance sheet through its sale of a Treasury security to the Fed is is something extra.

The Power and Independence of the Federal Reserve pp. 131-132

The money injected into the banks in this way is called “high powered money” because the banking system can multiply that money through the fractional reserve lending. If the reserve requirement is adjusted down, banks can hold less cash and the money multiplier effect is greater, expanding the money supply. If the reserve requirement goes up, banks can lend less of their deposits, resulting in less money creation.

Banks are generally in the business of taking the “something extra” and injecting it into the economy in the form of bank loans. Under normal circumstances, the bank will lend the cash it has received from the Fed in exchange for its more illiquid security. Doing so expands the money supply in the economy as the bank borrower spends that money and multiplies the money’s reach through a daisy chain of spending, investing, and saving.

Because most consumers of bank credit–usually businesses, but also individuals–don’t carry around much cash in their wallets or under their mattresses, the money the first bank receives through the Fed’s initial market transaction goes to another bank or business, which gives to another bank or business, and on and on. The effect is a more or less predictable expansion of the money supply throughout the banking system. ibid. pp. 132-133

In a financial panic the banks need cash. Based on the above, what happens? Rather than being locked up, money is set free. The Fed buys Treasury securities, i.e. government debt. Or it buys the mortgage-backed securities (which are theoretically backed by people paying their mortgages, except in the financial crisis they weren’t, meaning that they were essentially worthless paper). That’s why the debt increases. It has to. That’s how the system is designed. Remember, treasury securities are the government’s debt.

US Fed balance sheet increases to record $6.62 trillion (Deccan Herald)

So we see that the selling of bonds has nothing to do with the government needing to get the money from the private sector in order to spend. The sovereign never needs to “borrow” the currency over which it has the exclusive right to issue–that is logically ridiculous. It does so by convention (holdovers from the gold standard era and mercantilism), which ends up providing a risk-free asset–Treasury securities–for the private sector to hold cash. The selling and buying of this asset help to stabilize the price of money by injecting it into, or taking it out of, the banking system.

Of course, as we learned last time, the fractional reserve theory of banking is obsolete. Now that demand deposits are the main way of conducting transactions, and are treated like cash, the loan itself creates the deposit on the bank’s balance sheet.

In the [intermediation of loanable funds] (ILF) model [of banking], bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor.

The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involved no intermediation whatsoever. Third parties are only involved in that the borrower/depositor needs to be sure that others will accept his new deposit in payment for goods, services, or assets. This is never in question, because bank deposits are any modern economy’s dominant medium of exchange.

Furthermore, if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore…saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respecting macroeconomic roles of resources (saving) and debt-based money (financing).

Bank of England Working Paper No. 529: Banks are not intermediaries of loanable funds–and why this matters. Zoltan Jakab and Michael Kumhof.

So we saw three ways the Fed can influence the amount of money in the banking system, and hence, the economy: 1) Manipulate the fed funds rate by buying or selling Treasury securities; 2) Lower the discount rate; that is, the cost to borrow from the Fed 3.) Lower the reserve requirement—the amount of deposit money banks must keep in their accounts at the Fed.

What if the price of money is already so low that it’s practically free? Turns out that’s now. When that happens, rates can’t really go lower, so it’s a problem. We’ll discuss that another time.

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If a particular bank didn’t have enough reserves, it would borrow from other banks in the system, as we said above. But in a financial panic, when bad loans are roiling the entire system due to bad harvest or something, every bank is trying to make sure it has enough money to stave off a bank run, and no bank wants to lend out money. They can’t get a temporary loan from the other bank, because the other bank is in the exact same boat! And so on, throughout the entire financial system.

So in that type of environment, where would the banks get the money they needed? Who would loan it out? Often the answer was a bailout organized by wealthy Wall Street financiers getting the money from London or something. But after enough of these ad hoc rescues (the last one famously spearheaded by J.P. Morgan), everyone knew that some sort of permanent bank “above” all the others was needed to loan out money from the federal government during times of banking panic or financial crisis. And these banking panics used to happen a lot. And I mean a lot. As “Adam Smith” writes:

The framers of the law that created [the Federal Reserve] were literally panic-stricken. Schoolchildren once learned the dates of bank panics in history as if they were battles: the Panic of 1837, the Panic of 1873, the Panic of 1893, the Panic of 1907. Boom, bust, the agitated lines of depositors stretching out into the street, people anxious to get their money out while it was still possible; then collapse, and depression.

When Congress established this Reserve system in 1913, it contemplated that the Reserve could stop a run on the country’s banks with money that was not gold, not silver, not anything in the vaults. By a series of mechanisms, the Federal Reserve could add money to the government’s own bank account. Stricken banks would have a senior friend, and the Federal Reserve, the central bank, would regulate the county’s supply of money. This office had great financial power. PAPER MONEY, pp. 15-16

Thus, the Fed is the lender of last resort. Peter Conti-Brown describes:

Maturity transformation is what makes banks so vulnerable to failure. The system relies on an assumption that only a few short-term depositors will withdraw their money on a given day. When more depositors show up at a bank demanding even more in withdrawals than is on deposit in the vaults, the bank will fail unless new cash can be secured.

The first priority of a bank facing a panic, then, is to publicly and ostentatiously demonstrate that it has secured new funds, usually from another bank. As soon as the panic is stabilized, a bank with a well-managed portfolio will pay back both its emergency debts to the other banks that have stepped in to the breach and those the bank owes to its regular depositors. (In the sometimes confusing vernacular of banking, the bank’s “assets” include the loans it is owed by homeowners, business owners, and the like; its “liabilities” include the deposits that savers can demand at any time.)

If the panic spreads, however, the usual sources of short-term credit to the first scared banker–other banks–are themselves tied up trying to fend off bank runs of their own. At that point, a localized panic has become systemic.

In that event, banks scramble in a dash to find liquidity in the system, wherever liquidity can be found. The central bank is the solution to the scramble for liquidity. The central bank is the “lender of last resort,” the bank that exists to restore order to the financial system.

Peter Conti-Brown; The Power and Independence of the Federal Reserve, p. 152

So the problem with all the “End the Fed” dipshits is, how ya gonna stabilize the banking system, then? Or should we just let it crash every ten years?

In the bad old days, if a bank failed, you lost all your money. Now deposits are insured, up to a limit. If your bank fails, you will be reimbursed by the insurance payout for the amount you lost up to the insurance limit (so that $1000.00 in your account is safe.) This was an innovation of the Great Depression and it pretty much eliminated bank runs.

But, as you can see above, a lot of assets on the bank’s books are loans for real estate, i. e houses. There are always some people who default on their mortgages, or course. But if enough of those mortgages go bad all at the same time, then assets go poof, and the bank’s balance sheets become insolvent all of the sudden. And if it happens all over the entire country, then the above scenario applies—each bank is trying to save its own balance sheet, and so has no money to loan to other potentially insolvent banks in the system. The Federal Reserve has to step in.

And that, my friends, is what 2008 was all about.

Debt is a tradable commodity, and when wound back to the source somebody is paying that debt. And when they stop paying, that debt suddenly becomes a worthless commodity. Multiply that by a few trillion and you’ve got an economic crisis on your hands. So goes the financial system.

Making it worse was that the mortgage debt was “sliced and diced” into mortgage backed securities and traded all over the place. So some pension system in Oregon or somewhere was dependent on a bunch of mortgages in Las Vegas, and now it’s gone bust too. Plus, many had taken out insurance policies on these securities, and the underwriters assumed they’d never have to pay up. When everything went bad at once, the claims they had to pay overwhelmed the money supply they had on hand the insurance companies went belly-up too.

Why did this happen? Well, the banks made shady loans. And, in a perfect world, banks that made shady loans should go under. But when it’s endemic throughout the whole damn banking system, you can’t just let the entire banking system itself go under, because capitalism requires a banking system in order to function (which hopefully is obvious). So it’s got to be saved, and so some people who made the original shady deals got rescued too by default. Kind of like if terrorists blew a hole in a ship, and then got pulled from the water during the rescue along with all the other drowning passengers in the aftermath. It would have been nice if we had at least prosecuted the shady dealers in the courts, but, oh well, you know…

The problem now is that the money is disappearing because businesses can’t do business, and workers can’t earn money because they’re unemployed. Even those who are not unemployed are not spending it because 1.) they’re stashing it away because of uncertainty, or 2.) everywhere they would have spent it is closed. Nonessential businesses are prohibited by governments from doing businesses at all, and many workers can’t leave their homes except for essential errands and enjoying the outdoors while keeping their distance from everyone. With no revenue coming in, business can’t pay back their loans–and loans are the bank’s assets, remember. With businesses not doing business and people not earning salaries, money is disappearing, and loans are going bad left and right.

Because banks have accounts at the Fed, as we saw above, they are first at the trough for money. We ordinary citizens do not have accounts at the Fed. Although an interesting proposal suggests that maybe we should:

Now more than ever, therefore, we need an alternative to entrusting our security to institutions so prone to disaster, which is why Fed accounts for all is a proposal that is not only attractive and practical, but also urgent. Bankers can tell you that the Fed is an enviably indulgent loan-officer, charging minimal interest rates – currently 2.5 percent—on loans which, when passed on to customers in the form of credit card debt, carry hefty (17 percent!) profitable interest rates. So why shouldn’t the rest of us get in on the act?

This is no fringe proposal, having been advanced by a number of responsible authorities and even in a paper published last year by the eminently orthodox Federal Reserve Bank of St. Louis. The authors, two Swiss economists, proposed “central bank electronic money for all” allowing “all households and firms to open accounts at central banks, which then would allow them to make electronic payments with central bank money instead of commercial bank deposits.”

Forget Checks, How About Giving Everyone a Federal Reserve Account? (The American Conservative)

This would also allow the government to replace the lost paychecks from everyone either losing their job or being forced to stay at home:

Finally, this necessary reform would pave the way for an equally useful innovation: universal basic income. The notion of assuring everyone of a guaranteed income with no strings attached has been gaining increasing attention and support around the world in recent years, and in the presidential campaign of Andrew Yang. It has indeed been implemented in a number of locales with striking success.

One notable example, the Alaska Permanent Fund, distributes up to $2,000 to every Alaskan citizen every year. When the fund was inaugurated (by a Republican governor) in 1976 the state ranked highest in poverty rates in the country. Twenty years later, Alaska had the lowest. When the British Labour Party proposed a move toward UBI in its election manifesto prior to last year’s election, the proposal elicited a predictably choleric response from some, with the Financial Times sputtering that “rewarding people for staying at home, is what lies behind social decay”. Given that we are all now encouraged or forced to stay at home, the complaint seems ironic in the extreme.

Thus we see that the Fed is 1.) A lender who lends money to solvent banks when no one else can or will (lender of last resort); and 2.) The thing that manipulates the price of money by buying and selling securities in the market to keep the supply of money in line with what the economy actually needs. This results (hopefully) in not too much inflation or deflation.

We’ll talk about those two things next time.

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