if the FED does not get its members under control soon and force them to lend this economy is going to face a self reinforcing negative deflationary spiral that could result in cascading bank failures and a world wide financial crisis.
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Cash Flow
The money center banks are not lending. Money centers are large, international, US based banks, that are members of the US Federal Reserve System; i.e. JP Morgan, Citigroup, etc.
The US Federal Reserve, a privately owned central bank, was allowed to be privately created by an act of Congress in 1913. The member banks are the owners of the FED.
These FED member banks are taking the cash reserves placed in them by the FED during normal open market operations and using it to re-buy US Treasuries.
Normal open market operations are what the FED conducts daily and involves putting money into banks and taking money out of banks. This involves direct money supply manipulation and is separate from the Federal Open Market Committee, FOMC, rate adjustments of FED funds and FED discount rates which occur about every 6 weeks and get all of the media attention.
Open Market Operations are used to adjust the supply of money to banks.
The FOMC adjusts interest rates to manipulate the cost of money to banks.
The FOMC is the rate setting policy arm of the FED that was created by Congress in 1934 to help further smooth the supply and cost of money to the economy from the FED.
When these banks take the money that has been placed in them by the FED and use it to re-buy US Treasuries they have defeated the purpose of putting the money in the bank to begin with as well as the purpose of having a central bank.
In other words, the banks are now operating at cross purposes to the FED itself.
When the FED wants to increase corporate lending and borrowing activity it lowers the FED funds rate and increases money supply.
It increases money supply by removing interest accruing US Treasuries from their member banks; i.e. JP Morgan, Citigroup, etc., and replacing them with non-interest bearing Federal Reserve Notes, also called, although it is a misnomer, dollar bills.
The idea being that the banks now have to lend the cash; i.e. Federal Reserve Notes, out to companies in order to make money on it. This is the push side of the lending markets; i.e. lower rates and make money available.
The problem is that instead of lending the money out to corporate borrowers these banks are taking the cash and re-buying US treasuries on the bond market and even directly from the US Treasury, a publicly held institution, driving the Treasury yields down dramatically. The 10 year US treasury yield is at 3.71% as I write this, down another 7 basis points from Fridays close.
Remember, the FED replaced the Treasuries with cash to get the banks to lend in the first place.
When a bank holds US Treasuries it has, in essence and fact, made a loan to the US government or bought a loan from someone else that had already been made to the US government, a risk free loan at that.
But, if all the banks ever did was lend money to the US government they wouldn't serve any functional purpose, economically, socially or politically.
Coupled with this is the fact that these banks are also right now increasing their lending rates and qualifying standards to make it even more difficult for corporate borrowers to borrow money for capital spending needs.
This, even though the FED is making money cheaper to the banks.
One of the primary reasons for having a central bank, the US Fed, and for having that bank increase money supply and decrease rates; i.e. the cost of money, during economic slow downs, is to offset the slow down by making money more easily accessible.
When banks increase their commercial lending rates even as the FED is decreasing the cost of money to the banks the banks have broken their good faith responsibility to society as well as their legal obligation as FED members.
The bankers claim they are upholding their legal and financial responsibility to their shareholders, bondholders and depositors. This responsibility typically requires prudent, risk mitigating lending strategies. They offset the increasing risk of principal loss on new loans by restricting lending and increasing the cost of borrowing to compensate for it.
So, we have two seemingly opposing priorities.
Which of these two is the fiduciary responsibility of the bank is the question.
The answer is really very simple. The social obligation takes precedence and is the fiduciary obligation of the banks. This set of priorities was established in 1913 when the FED was created.
The other aspect of this that solidifies this set of priorities is the social obligation to the banks during a crisis.
If the banks abide by the social contract and act in a counter-cyclical manner during a crisis and they still lose money then society is obligated to bail them out; i.e. the tax payer foots the bill.
But, keep in mind that this requires that the banks abide by their FED member mandate and increase lending at reduced rates to their commercial clients.
Since it is, in essence and fact, public money that is being deposited into the banks by the FED these banks must abide by the FED mandate and pass this money along to their borrowing commercial clients at a rate reduction corresponding to that which was supplied to the banks by the FED.
As the FED lowers rates and puts money into the banks the banks have an obligation to do the same for their clients and pass the reduced cost of money on to them.
So, the banks responsibility to their shareholders and bondholders may only take precedence if they will not request or accept a tax payer funded bail out in the event of an internal crisis at the bank that is a direct result of the bank violating their good faith responsibility to society.
But, since the creation of the FED does not allow member banks to determine whether or not they will accept or reject a tax payer funded bail out the argument put forth by the banks is moot.
The FED and their money center bank members are in essence quasi-public institutions, just as are the GSE's, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
They are not distinct private institutions.
The S&L bail out made this clear as well. It was, and is to date, the largest publicly funded bail out of private financial institutions in US history and the largest one sided transfer of public funds to private firms in the history of the US, having cost tax payers about 130 billion dollars.
The consideration that allowed the banks to accept the tax payer funded S&L bail out, and still remain private, was that the crisis was caused by bank and S&L regulation. In essence and fact the argument was that the banks were held hostage to bad regulation and thus the public was responsible for the S&L collapse and subsequent need for tax payer funded cash infusions.
The government, as the argument goes, caused the problem so the government, funded by tax payers must pay for it.
All well and good.
But the bankers went further afterwards saying that if the banks were allowed to operate unfettered by 1930's New Deal legislation; i.e. Glass Stegall and many others, that they would be able to operate more efficiently and reduce their lending risks, thereby ensuring that another tax payer funded bail out would not be required.
Glass Stegall was the act, passed by Congress, and enacted in the early 1930's, that separated liabilities based financial firms; i.e. banks, from doing business with asset based financial firms; i.e. insurance companies and stock brokers.
As deregulation has been the US bi-partisan national political hallmark of the past 30 years the banks were given what they wanted and Glass Stegall was rescinded in October of 1998.
It was that recission which allowed Travelers Insurance, an asset based financial firm, led by Sandy Weill, to conclude it's April 1998 take over of Citicorp, one of the largest banks, i.e. liabilities based financial firms in the US and create CitiGroup.
It was this same deregulatory atmosphere of the time, 1990's, that allowed for the consolidation of two large money centers into one, JP Morgan and Chase. Which were themselves the amalgamated results of other large money centers.
Today banks are making a similar statement. The claim is that the risks of lending have increased faster than the FED has lowered the cost of money and the only way to compensate for that is to increase lending rates. The increased risks they claim are not economically driven but caused by corruption and dishonest borrowing practices by their clients; i.e. Enron, Global Crossing, AOL, etc.
This is where the moral hazard and social obligation come in as legal concerns.
Bankers are not omnipotent. They incurred a moral hazard and shared responsibility for having made bad loans regardless of the fact that they may have been lied to by some of their clients.
To increase the lending rates to all borrowers in an attempt offset the risks of lending to corrupt borrowers is an attempt to transfer the banks responsibility and past mistakes on to their current and future clients rather than to assume it themselves.
This can only result in further loan loss problems at the banks as previously honest and viable borrowers are now squeezed out of the capital markets because their competitors lied.
So, the FED is trying to fight the slow down and inherent increasing risk in lending money by making money cheaper to offset the risk. This is known as a counter-cyclical event; i.e. as risk goes up loan rates from the FED to the banks decreases.
However, this only works if the banks lend and the borrowers borrow. Neither is happening. In essence the FED is now fighting with its own members.
The banks are taking the money that is being put in them by the FED and they are turning around and re-buying US Treasuries on the open market, thereby making the FED's increase in money supply moot.
This allows the bank to arbitrage (risk free) the FED's increase in money supply and create risk free returns for themselves. They can borrow at the FED rate of 1.5%-1.75% and invest in US treasuries at 3%-4%, thereby creating a risk free return of 1.25% to 2.25%. And that is exactly what the banks are doing.
So, the FED, by lowering the FED funds rate and increasing money supply WITHOUT requiring the member banks to lend has in essence decreased the probability that the banks would lend. Because banks can create the risk free return they don't need to lend.
In other words the FED's rate reductions are resulting in the exact opposite of what it intended.
There are three options available to correct this issue. I will address them in descending order of preference here.
First, the FED can order the member banks to lend. This is the first thing that should be done and done immediately.
Second, the FED can open the FED discount window to corporations allowing them to bypass the banks and borrow directly from the FED. This would be self defeating as it would cause a crisis flee out of the US economy, dollar and markets.
Third, The FED can INCREASE the Fed Funds rate, thereby decreasing the risk free profit available to the banks and making it more probable that they will lend to companies to create returns. This would send a signal to investors that the FED is out of control of its own family, i.e. member banks, and cause a flee from the US economy, dollar, and markets.
So, why hasn't the FED taken an assertive public stance on this issue and urged member banks to lend?
I don't know.
What I do know is that there is now a restriction point in the way money is disseminated through the banks to the economy and that point of restriction is the banks themselves.
The pushing on the string scenario typically requires that there be few or no borrowers to lend to.
But, if the banks abided by their FED mandate and social contract and reduced their lending rates into this slow down and made money available to the economy in the counter-cyclical way they are obliged to as members of the FED this economy need not stall further.
It appears right now though that we are moving in the exact opposite direction. The failure of the FED to get its members to lend has validated the decision by these members not to lend and set the course for a potential tax payer funded bail out of unprecedented proportions.
The longer the economy is suffocated of the cash it needs the less likely it is to respond positively to the cash when it is made available.
In other words, if the FED does not get its members under control soon and force them to lend this economy is going to face a self reinforcing negative deflationary spiral that could result in cascading bank failures and a world wide financial crisis.
This is even more ominous now that the world is in a ge-synchronous global slow down. The US banks ironically are in a better position than anywhere else in the world.
Japan has collapsed but has refused to acknowledge that fact yet.
Germany will collapse as the reforms necessary to salvage their banking system will not happen. The loss of legislative control of the Government by Shroeder, even though he was reelected, has in essence left Germany with a lame duck federal government.
The near term probability of negative economic and market developments all over the world from here is almost absolute.
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