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By Shah Gilani
Contributing Editor
Money Morning
“The truth? You can’t handle the truth.”
The truth is, the U.S. Federal Reserve does not directly control the Federal Funds rate, and its efforts to reduce the benchmark rate from 2.0% to 1.5% may do more damage than good – though for reasons you’d never guess. Attempts to lower the Fed Funds rate could irreparably damage Fed credibility and may actually narrow the Fed’s credit-crisis-management options.
The Fed Funds rate is the interest rate that banks charge one another for overnight loans. Under normal circumstances, the Fed Funds rate is the central bank’s primary and most effective tool in influencing interest rates. But the current market situation is anything but normal.
Contrary to what most people think, the Fed Funds rate is a “target;” it is not an absolute number that anyone actually has to follow. The central bank’s policymaking arm, the Federal Open Market Committee (FOMC), resulting principally from its deliberations on the outlook for inflation, and secondarily the general state of the economy, raises and lowers interest rates throughout the financial system and the economy by targeting the Fed Funds rate.
Before the U.S. financial markets opened on Wednesday, Fed policymakers, headed by Chairman Ben S. Bernanke, announced that the central bank was lowering the Fed Funds rate half a percentage point to 1.5%. The idea is that, the lower a bank’s cost of money actually is, the cheaper the rate at which it can lend to others and still maintain a decent profit margin [For a complete discussion of cost of funds, and of the overall lending process, take a look at yesterday’s Money Morning report on the commercial paper market. The report is free of charge.] Banks compete with each other to make loans. If they have lots of money to lend, they compete for business by lowering the interest rates they charge borrowers. The more money banks have, the lower interest rates go.
If the Fed lowers the rate at which banks borrow from one another, it stands to reason that banks will generally pass their lower cost of money along to borrowers. And that means the lower resulting interest rates will stimulate capital formation, production and consumption – and with it, the entire U.S. economy.
Well, at least that’s what’s supposed to happen. But here’s how it really works.
Every major bank has a Fed Funds trading desk. The job of a bank’s Fed Funds trader is to buy or sell money overnight, or for longer periods. There are two reasons why banks buy and sell money:
- First, if a bank has money in its vault that it could – but hasn’t – lent out, that money does the bank no good just sitting there, not generating any interest income for the institution. So the bank’s trader actually calls around to other banks to see who wants to borrow some money.
- The second reason is actually far more critical and is always the bank’s first consideration: The Federal Reserve requires that banks keep at least a specified minimum of reserves in their vaults. That means that each and every evening, as the Fed tucks a bank in for the night, it always makes sure to ask: “Have you met your reserve requirements tonight?” If a bank has made a lot of loans that day, it may be short of cash to meet its reserve requirement ratio. If that happens, the bank’s Fed Funds trader calls other banks and borrows enough money to cover its reserve requirements.
Generally speaking, the interest that banks charge each other is close to what we know as the Fed Funds rate. If the Fed lowers the Fed Funds rate, theoretically the cost of money at which banks lend to one another is lower, too. In theory, then, if all banks have met their reserve requirements, and if they all have money to lend to each other overnight, and because money that doesn’t get lent out doesn’t make any interest, banks will lower interest rates for borrowers so that the money in their vaults is put to use and earns interest.
Here’s the rub. In order for the Fed to actually change the Fed Funds rate, it must itself go out into the market and buy and sell securities. The Fed executes open market operations through the New York Federal Reserve Bank, the most powerful of the 12 Federal Reserve Banks.
If the Fed wants, as it does now, to lower its Fed Funds target rate, it has to initiate the process. In order to add cash into the banking system, the New York Fed buys Treasuries from dealers and pays cash. The transaction is called a repurchase agreement, or “repo.” The result of this transaction, when done to the tune of billions of dollars, is that dealers now have billions in cash that they can deposit into banks. Since, banks theoretically now have a lot of cash to lend to one another overnight, they will lower the overnight rate that they charge each other.
The Fed must inject enough excess cash into banks’ vaults through its open-market repo operations to make sure the banks actually lower the overnight rates they charge one another until that rate approximates the central bank’s Fed Funds target rate. That’s the reality of how the target rateis reached.
But, as usual, there’s the story – and there’s the story behind the story.
Traditionally, when the Fed executes repurchase agreements, it buys U.S. Treasuries and pays cash for them. The Treasury securities the central bank buys becomes part of its balance sheet. Now, however, dealers and banks are loath to sell any Treasuries. Why? Because Treasuries are the only security on dealers’ and banks’ balance sheets whose actual worth they know. They’re not parting with them.
Because the Fed is determined to add liquidity by providing loans and easily marketable securities to banks and dealers through its discount window and term auction facility, it is already taking in all manner of other securities, including equities, against which the Fed is lending Treasuries from its own balance sheet. If the Fed wants to lower the Fed Funds rate, and dealers and banks aren’t going to sell it any Treasuries, the central bank will have to take in other securities (toxic junk) as collateral against the cash that it hopes to inject into the banking system through its repurchase agreements.
Just how depleted and how damaged the Fed’s balance sheet may become is a major concern. But, that’s not the immediate problem.
Lowering the Fed Funds rate may not work at all.
Just because the Fed floods banks with cash doesn’t mean that banks will lend each other money – at the targeted Fed Funds rate, or at any rate. Banks are all fearful of each other – I’m talking on a worldwide basis – they are increasingly hoarding cash as a cushion against their own upcoming losses. They’re facing increasing weakness in their commercial-loan and commercial mortgage-backed securities inventories (the next shoe to drop). And banks are increasingly facing heightened exposure to leveraged loan portfolios on their books that they can’t off-load, and rapidly deteriorating credit-card-based securities and portfolios.
If the Federal Reserve is unable to facilitate overnight-bank lending, and is unable to actually lower the Fed Funds rate to its target rate of 1.5%, what will that do to its credibility? It is devastating that we have no trust in our banks; but if we also lose trust in our central-bank firefighter’s ability to quell the financial conflagration, the darkening skies may make the last three weeks seem only partly cloudy.
The Fed and the U.S. Treasury Department have done a good job in addressing, publicly, what needs to be done. Unfortunately, they have both made the cardinal sin of actually showing us their hands, when they should have played their aces earlier and controlled the game.
Now the whole world is watching.
And since we know the hand we’re all playing, it’s only a matter of what cards are turned over that will determine our future.
On Monday, I’ll show you the Treasury’s hand and tell you why that game is already lost.
We need to drop these games, reshuffle the cards and play this out as the “house” with greater odds in our favor. It can be done by Election Day, but we’re going to have to take the politics out of the game – once and for all.
Can we do it?
[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action. It's a perspective on the near-financial meltdown that more than 140,000 readers have already read – and an insight that you'll find nowhere else.
If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. It actually contains contact information for readers who still wish to protest the government’s action with the bailout bill by passing their disenchantment along to their elected representatives in each state’s governor’s mansion, and in both the House and the Senate. Check out Gilani’s plan of action.
With the U.S. financial markets in such disarray, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises – while the rest of Wall Street tanks. Not only does this company have a lock on China – the fastest-growing market on the planet – this corporate gem is also riding the profit wave of the most-powerful global trend that we're following right now. If you act on this opportunity now – as an added bonus – you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse."]
News and Related Story Links:
-
Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One’s Talking About. -
Money Morning Special Investigation of the Credit Crisis (Part II):
The Credit Crisis and the Real Story Behind the Collapse of AIG. -
Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System. -
Money Morning Special Report: How to Fix the Credit Crisis (Part IV):
Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers. -
Money Morning Special Investigation of the U.S. Credit Crisis (Part V):
Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers. -
Money Morning Special Investigation of the U.S. Credit Crisis (Part VI):
Credit Crisis Update: An Inside Look at the Commercial Paper Debacle -
Wikipedia:
Federal Funds Rate. -
Money Morning Market Analysis:
By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System? -
AllExperts.com:
Using Banks and Bank Accounts; Cost of Funds. -
Wikipedia:
Mortgage-Backed Securities. -
Wikipedia:
Commercial Paper. -
NASA History:
Apollo 13: “Houston, We Have a Problem.” -
Reuters Financial Terms Glossary:
Matched Book. -
Wikipedia:
Discount Window. -
Wikipedia:
Term Auction Facility. -
Wikipedia:
Federal Deposit Insurance Corp. -
Money Morning News:
Federal Reserve to Buy Commercial Paper to Free Up Frozen Market. -
Wikipedia:
Federal Open Market Committee. -
McClatchy Newspapers:
Fed's half-point rate cut proves no match for Wall Street's fear.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.
Thanks for the lesson and increasing my interest in economics.
No, it cannot be done.
Globally, the “house” is divided.
This is very informative. Thank you very much. I've been a bit mystified about the activities of the Fed, and now I feel at least I have some base understanding.
I have never understood this. The first step is that the Fed lends to the Treasury. In other words, the Fed purchases bonds from the Treasury. Thus, the Fed ends up with the bonds, and the Treasury ends up with the borrowed money. Somehow, though, whatever follows assumes that the Treasury is the one with the bonds.
Mr. Gilani,
I cannot agree at all that the Fed and Treasury have publicly addressed what needs to be done. It is obvious that neither can investors, who are currently voting their confidence in the moves being made by regulators, with their dollars – and the lack of them.
As you have pointed out, this isn't actually a crisis of liquidity, nor of mortgage defaults, but of trust. The underlying cause of the present difficulties are not subprime borrowers, who could have paid back their loans handily had asset price inflation continued apace, but the sharks and swindlers that passed them bad paper, and fraudulent advice to accept loans with interest rate resets, as well as the sleight of hand accounting by banks and hedge funds that made CDS's and SIVs appear to be sound financial practice.
The markets plummet not because investors can't raise capital to purchase stocks, although they can't, but because they won't, because they can't trust the instruments in which they might invest.
The moves by the Fed and Treasury to further the murk in finance by creating of Henry Paulson a 'Finance Czar', to end mark to market accounting, and bail out the swindlers and frauds rather than the homeowners themselves, are all insults added to injuries already suffered by investors.
These are exactly the wrong moves, and can only worsen this crisis, decreasing the confidence of the American people, and investors globally, in the Federal Reserve system, and the US government. It is become obvious that this crisis is intentional, as merely guaranteeing the underlying mortgages and removing the interest rate resets would have prevented this entire problem, and at but a fraction of the cost of the bailout, much less the multi-Trillion dollar wipeout ongoing in equity markets, while enabling the first victims of this present trouble, the defrauded homeowners, from suffering the loss of their homes.
By law, the moves that should be undertaken are that the insolvent entities should be seized, the fraudulent operations terminated, the perpetrators indicted, and the criminal enterprise called the Federal Reserve Bank replaced by government issued 'greenback' currency, which can be lent immediately to the American people, and permit the usurious and fraudulent unholy load of debt claimed by the Federal Reserve to be safely and profitably repudiated.
While this won't happen, unless the American people find a FIRE sale on pitchforks, torches, balls, and spines, it is indeed a pity that is so. Fortunately, the banks of the EU aren't buying the bs being shoveled by Paulson and Bernanke, and are more carefully, and less profligately, underwriting their troubled banks and funds.
While their failure to repudiate the present debt based monetary policy leaves the potential for dramatic failure, now and in the future, at least they're not throwing gasoline on an out of control blaze, as is US policy.
Finally, markets infested with fraud and based on usury – which increases geometrically, while production can only increase arithmetically – are not free at all, but rather predatory free-for-alls, designed to elevate the most rapine and malicious at the expense of the prudent and industrious.
Truly free markets prevent fraud, promote honest industry, and are based on equitable and prudent investment, rather than the inherent swindle that is debt based monetary policy and fantastic usury, a pretense that money can grow faster than industry can produce it. Forthright and profitable monetary policy isn't rammed through a corrupt Congress in the wee hours, while honest people begin their Christmas holiday, as was the Federal Reserve Act.
It's time to set that crooked path straight, and put paid to the debts foisted on America, and the world, by corrupt officials and swindling banksters. This crisis proves that, if nothing else.
I have read this series with interest; it gives an excellent analysis of the problem; however, I believe that Mr. Gilani is not familiar with the banking industry or the operations of the Federal Reserve. If there is one single thing the Fed can control, it is the Fed Funds rate. Doing this however, as Mr. Gilani notes, requires Treasury securities. It appears quite likely that the Fed has lent or otherwise committed its entire $800 billion in assets, so that it has an inadequate supply of Treasuries.
The important thing about the $700 billion bailout, which most people have missed, is that it lifts the government debt limit by that amount. The Treasury can now borrow $700 billion more than it could before, and since the Fed acts as the government's underwriter and banker, the securities initially go on the Fed's balance sheet, and the proceeds of the issuance of those securities are deposited into the Treasury accounts at the Fed. The net result of this operation is that the Fed balance sheet expands from $800 billion to $1.5 trillion. The Fed is now in position to supply the demand for Treasury securities through the discount window by swapping the Treasuries for up to $700 billion of additional illiquid securities which banks hold.
In my view, the reason Paulson was so vague about how the plan was going to work, and also the reason he was willing to accept conditions from Congress that almost completely undermine the purpose of the bailout, is simply that he hopes actually to spend as little of this money as possible while giving the Fed the firepower to continue its role as lender of last resort.
In a sense, the bailout is a bailout of the Fed. The Treasury does not really suffer from borrowing this money early. The interest rates are now so low that payments are nominal, indeed on some recent days investors have paid the government to take their money. And it will need the money soon enough anyway.
And as Paulson has said, the long range solution must be found by the incoming administration and Congress. Good luck, President Obama. You will need it very soon.
Well I have to agree with Mr. Gilani to a certin extent ; the Fed & Congress are going about this the wrong way to a certin extent… I agree that they should take a equity stake
in the banks that they help & that they should buy some of the debt from the holders of said toxic debt .. But thay should buy it at a discount of 30% to 50% of stated value ..
But he simple way to have delt with the main issue would have been & still could/should be is to have the holders/lenders or banks ddiscount , write down all of the loans that they hold ; depending on the fall in value of said
properties in the areas they are in ; some areas / markets
have fallen more than others… or the othe option would have been / still could be ( & probley the best one is just drop the instrest rates on all the loans they are holding to 4.5% &
fix them for 30 years at this rate .. )… For the hardest hit
areas where the martket value has fallen 30 to 40 % ; not
only should they adjust the loan rate but the amount of the loan …It would be cheaper than what they are doing now
selling the homes for 50% of what the original amount was
plus the cost of foreclosure , repair & cost of resale….
This could be done over night if Congress , the Fed & Treasury would get together .. At the same time by injecting
the banks with funds they would free up the credit markets ..But they would have to make it understood that if
That if they help the banks out with funds that the banks
would have to loan any funds above the amount needed to
keep the regulators happy…But as you see the Fed & Treasury are run by Bankers / Brokers.. & as you well konw bankers when there is a problem tuck their tail between their leggs & put their heads where the sun doesn't shine … They allways get it wrong/ backwords….Then keep Fanni & Freddi as goverment enities that is where they started … all the lonas they hold provid income ; use it to pay off the national debt… These actions would help main street & at the same time help the lenders/banks with their cash flow……
We can agonize and babble about this “threat” ‘til we’re blue in the face, but by so doing, change nothing.
As individuals, or as collectives of individuals, we exercise “no control” whatsoever over what is “far beyond” reach.
Here is a reality check:
This thing called “money” and “all” that we’ve been taught it means since the day we came into the world, is now “broken” and cannot be “fixed”. This false valuation “idol” that we’ve carried around within our hearts has been, in our time, finally “exposed” as worthless.
It always was a “false” representation of human “value” if only because of the outrageous “misery” inflicted to those “blocked” from adequate access to it. But, now, “everyone” is about to “know” the pain of existing “without”. The world’s playing field is “equalizing” or “leveling out” for all to “see”.
Governments, by their “central banks” are already taking control of “valuation” from the hands of traditional banking regimes in order to “fix” money. With this desperate action, we will eventually, and quickly, see the demise, around the world, of all traditional banking regimes along with their money market exchange devices.
So-called G7 leaders, amid ongoing emergency meetings, are already “divesting” banker custodians of their long-held power. This action exasperates a final panic “freeze” among the world’s banks, which will result in their “split” into “three” separate “non-cooperating” entities. They split up because they don’t trust each other.
Central banks will then “exclusively” try to run the commerce of the world.
Is this going to work?
But, for a time!
I think "Valued Customer" may have a point when he says that the obvious solution — helping homeowners — is being ignored and that the most improbable and least useful step, nationalization and further concentration of finance in the hands of the largest banks and the most corrupt institutions may be deliberate. Welcome to the National Socialist (Nazi) system of the 1930s.
On a more critical note, why do you use this unreadable green for comments — do you want to discourage them?
Finally, you have a link promising a dream investment in Wisconsin (my home state) that says "For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises "- but it actually leads to a rather sleazy come-on beginning "Special Bulletin — The “Super Crash” May
Soon Devastate Millions Of Americans…"
Since Nixon in 1974 removed the gold standard for the dollar, largly due to France's demand for the gold in exchange for the dollars they held at the time , the World has been on a financial merry to round and now must jump off.
Paper money will become worthless and gold and silver, just like in the time of the Romans will be the median of exchange unless the World goes back to the gold standard within the next two years.
Bush warned us two times. McCain tried once to pass a bill to stop the sub-prime mess. Who in their right mind would lend money to people who can not repay the loan! Only politians buying votes in 1977 and 1979.
When I left graduate school I lived in apartments until I could afford a house. At 32 I purchased a small house. At 39 I got married. Maybe I was slow, but I was careful. That is better for the economy than being reckless.
I leave it to those educated in these things to construct the methods necessary to accomplish this suggestion.
Why not refinance all of these problem loans, those that started life as ARMS or interest only or anthing else that would morph into high interest loans, into 30 or 40 year loans at low fixed rates.
There is no excuse for lowering the face amount of the mortgages. So what if they're underwater. Underwater only matters if refinancing is necessary. Everyone who ever buys a house with a mortgage faces the possibility of one day being underwater. If the buyer has misjudged the market, that is his responsibility. Those who "bought" houses they couldn't afford (even if the interest rate were to have remained low) absolutely do not deserve to keep those houses while the rest of us, who either bought houses we could afford or didn't buy because we could not afford to, pay (through our taxes) for the imprudent buyers to stay where they don't belong.
The pain of the costs associated with reducing the interest rates from the prospective (or already real) punishingly high rates should somehow fall on all the players who fed at the trough of this slimey scheme. That should, as much as possible, include the foolish buyers (dealt with in the paragraph above), mortgage brokers, the mortgage companies, the banks, the investment banks, the ratings agencies, and the investors (especially hedge funds) who chose to believe that higher rates of return didn't suggest higher risk. Oh, and find a special place in hell for the creators of credit default swaps and other "sophisticated" derivitives. As I said above, I leave the mechanics of seeking to achieve all of this to those with the necessary capability.
If this results in bank failures, so be it. If the FDIC can engineer the saving of worthy banks, find. If not, fine. Those who lived high on the hog while ignoring the damage they were doing should pay.
If the FED is actually part of the problem, let's look for a better system, and start over. We don't have to live with them any more than we have to live with the banks that failed to assess the risks of the mortgages they facilitated.
Gilani's analyses are excellent. Just one technical point. The credit problem of the banks is actually worse than what Gilani has described due to the so-called credit multiplfier effect as described by Keynes. That is, commercial banks do not just lend money that is deposited or borrowed. Commercial banks actually "create" money by lending. This is the endogenous theory of money.
For your reference, form Financial & Investment Dictionary:
Deposit multiplier or credit multiplier: magnifies small changes in bank deposits into changes in the amount of outstanding credit and the money supply. For example, a bank receives a deposit of $100,000, and the Reserve Requirement is 20%. The bank is thus required to keep $20,000 in the form of reserves. The remaining $80,000 becomes a loan, which is deposited in the borrower's bank. When the borrower's bank sets aside the $16,000 required reserve out of the $80,000, $64,000 is available for another loan and another deposit, and so on. Carried out to its theoretical limit, the original deposit of $100,000 could expand into a total of $500,000 in deposits and $400,000 in credit.
In other words, when bank credit is forzen,the negative effect of reduced credit is also multiplied.
"To The Rescue"…
I just like to know two thing!
Would our government be smart enough to put a financial bailout package to rescue our national small businesses?
With the same principles and energy they have spent to rescue Ford, Chrysler, GM, AIG among others.
or…
Would our government be smart enough to put a financial bailout package to rescue our tax payers families?
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