Basic question on Fed working

Just shows how difficult these things are to understand. My understanding is different.

When a retail bank funds a secured loan they create the money out of thin air, give it to you as a credit in your bank account and record the same amount as a debit or liability on their balance sheet. This liability is balanced by the secured asset that they have entered as a claim on your purchase. In this way fractional reserve banking allows banks to loan far in excess of their working (tier 1) capital.

The Fed does much the same, although as Travlin states, they don't act directly with Treasury but through the intermediary of Primary Dealers. The main reason seems to be to add smoke to the transaction as part of their smoke and mirrors obfuscation,

My understanding is that the FED is creating money and it is the treasury that is creating debt.   The treasury creates bonds, which are a general obligation of the US citizens, to finance the government operations and generally sells these through its network of primary dealers.  However if an individual or normal institution buys these bonds, no new money is created.  In this case existing money is loaned to the US government at interest. 

If a bank is the purchaser, it also must use existing money to buy the bond but it can then use that bond as reserves for its fractional lending and therefore create ~ x10 the bond value in new loans.  The problem right now is that the banks have tons of excess reserves that are not being fractionally loaned out right now because in reality there are not enough good creditors to loan money too. 

The final option for purchasing of government bonds is the FED.  When the FED buys bonds, money is created out of thin air and the bonds are added to the FED balance sheet.  The FED is not constrained like a normal bank by fractional reserve or anything else except the possible fear of congress getting wise to their scam and starting to take a more careful look at their operations and balance sheet.

Because the whole system is based on growth, and can potentially collapse into a black hole of debt if the money system is not growing, the FED has decided that it is worth the risk and basically stated it will create $600 of new money to finance the governments operations and keep interest rates lower than they would otherwise be.  This could work in the short term, while money velocity is low, but it is hard to see how this creates anything but more problems in the long term.

I kind of wonder if Peter Schiff is right and this is all just a ruse to allow the FED to step in if/when an auction fails.  I also thought the person at zerohedge had it spot on when it discussed how the Democrats/Republicans are arguing about a few % change in the income tax, while the FED without any oversight, is doing actions that could potentially devalue EVERYONES income and savings by >10% seems completely crazy.  I guess it is just the morally bankrupt system we live under until we END THE FED!

For me, it helps to look at the Federal Reserve's own H.4.1 statement, issued every Thursday evening. The latest one shows the following holdings:

U.S. Treasury securities ... $839.990 billion

Federal agency debt securities ... $149.681 billion

Mortgage backed securities ... $1,051.037 billion

http://federalreserve.gov/releases/h41/Current/

If the Fed buys $600 billion more of Treasuries, then their Treasury holdings should rise from $840 billion to $1.44 trillion.

However, the Fed also has said that as the principal of their mortgage backed securities is paid off, they will reinvest those payments into Treasuries too. This amount can only be estimated, not known exactly, since it depends on home sales and refi rates. But if $300 billion of MBS principal is paid off, then the Fed's MBS holdings would shrink to $750 billion, while the Treasury category could rise as high as $1.75 trillion.

All of these third-party debt securities add to the monetary base, which consists mainly of currency and banks' reserves with the Fed. As the Fed's H.3 report shows, banks already have $969 billion of excess reserves at the Fed. Presumably QE2 will increase their excess reserves to the $1.5 to 2.0 trillion level. But since reserves are not constraining bank lending now, it's unclear why even higher excess reserves would have any direct effect.

http://federalreserve.gov/releases/h3/Current/

Bensane Bernanke has stated that he wants to 'influence expectations.' Posing as a mad inflationist with a sorcerer's assistant printing press that won't stop has certainly changed perceptions, that's for sure.

Plato, Thanks for putting that YouTube piece.  I already had a good idea the way things work, but Ron Paul does a great job of explaining the Fed.

Gee Goes.  I was just helping a lady with a question and now you’re going to make me work.   That’s okay.  I know you study this issue seriously and you are rational and judicious in evaluating arguments and data.  Let’s focus on the primary issue and see what evidence I can provide for your consideration.

First a caveat.  I’ll qualify my statement to say that loans are primarily funded by deposits, and secondarily by borrowing from other institutions.  I am describing the classic principles of banking as still practiced by smaller banks.  No one really knows what the giant banks are doing anymore, including their own executives.  During our present period of near zero interest rates markets are seriously distorted and more anomalies appear.

Item 1 – Why do banks work so hard to attract deposits if they don’t need the money to fund loans?  You can be sure this is not just a public service.  Remember loans are the primary profit center for banks.  It is very expensive to build branches in every neighborhood, employee many people to handle small transactions, provide security for the cash, pay interest on deposit accounts and CDs, and process transactions in checking accounts.  Why don’t they charge you for keeping your deposits safely stored and electronically accessible?  Why do they pay you interest instead?

Item 2 – Look at the numbers.  Select any community bank where you live.  Their balance sheet should be publicly displayed in the lobby.  As for a copy.  At most banks you will find the total for loans is less than the total for deposits.  Even if they juice up their loan capacity by borrowing from other banks, it will be a small proportion compared to deposits.  You should ask for definitions of the line items so you can identify what numbers to use, but they are simple to add and compare.  The chief financial officer may be happy to help you, especially if you say you are looking for a safe bank to do business with in light of the financial crisis.  He can do this with a short phone call as you look at the balance sheet.  You don’t have to believe any propaganda.  The numbers are conclusive for our purposes.

All banks file standardized public reports quarterly that are available online at https://cdr.ffiec.gov/public/ManageFacsimiles.aspx  Select the Call\TFR report.  Here the balance sheet is deconstructed and itemized so it is hard to pick the relevant numbers, but knowledgeable people can analyze any bank in the nation from the comfort of their own home.  Maybe you know someone from your former employer or an accountant who could help.

Item 3 – Why don’t trees grow to the sky?  If loans are not limited by deposits then why can’t your community bank with one branch fund all the world’s credit?  I’m exaggerating here to make a point.  If bank loans are funded by borrowing then they should be able to write any amount of credit-worthy loans, because someone would be happy to supply the funds.

Investment banks used borrowed money to make loans and risky investments.  They were not regulated because they didn’t have retail deposit operations so people’s savings were not at risk.  They leveraged themselves to insane levels until they blew up.  However they grew to gigantic size  first. Commercial banks before the repeal of Glass-Steagall where very staid in comparison.  After the repeal in 1999 the lines blurred and after the crisis of 2008 (a wholly predictable result) the remaining investment banks were allowed to convert to commercial charters.  The was the only way to “save” them by allowing access to the Fed and numerous benefits they didn’t deserve.  But I digress.

Item 4 – Deposits are cheaper than borrowing from another bank.  Despite the costs outlined above, a well run bank can accumulate deposits for less cost than borrowing from another bank.  That is another reason why they borrow after they have exhausted deposits as a source of funds, and the amount borrowed is a small proportion compared to deposits.  If they just borrowed to fund loans they would be a finance company which is a different animal.  Deposits are in effect a lot of very small loans to the bank by individual customers.  The customers can "call the loan" for payment in full at any time.  I’m sure you’re aware that interest on savings is always less than interest on loans.  This “spread” is a bank’s primary source of profits.

Thoughts – I have serious doubts about banking as an institution.  Its social utility may be outweighed by its costs.  We all need to know more about this.  However, I think it is important to be objective and factual.  Before we can honestly criticize the results of banking we first have to understand how they actually work.  Flawed premises can lead to some wild conclusions that are not supported by observable events.  I just try to keep the debate sound to the best of my knowledge, which is incomplete.  I’m open to persuasion by good evidence.

I know you’re doing your own research and I’m interested in your conclusions or questions Goes.  Hope this helps.  It should give you plenty to think about.

Travlin

Goes

With all the attention to the nefarious practices of the mega banks it is easy to forget that probably the majority of banks still plod along using traditional practices.  Nowadays when we hear the word “bank” we immediately think of the un-indicted criminal enterprises that have captured our government.  I think there is good reason to debate the social utility of traditional fractional reserve banking.  I just try to help people keep the facts straight. 

Thanks for making me work.  It was good exercise for my mind.

Travlin

Hi Carl

What you say is correct except for one technicality.  Capital is the money the bank owns free and clear.  Borrowed money can be used to fund loans, but the bank will have to pay it back so it is not capital.  Capital is used to fund loans in some circumstances.

I just thought of another quibble regarding CDs (time deposits).  What you say is logical, but in practice the demand accounts, which include checking accounts, are actually more stable.  The aggregate average balances are pretty predictable and people are very reluctant to go through the headache of changing their checking to another bank.  The CDs are the “hot money” as people chase higher yields.  With the advent of the internet they are easy to find and buy.

This is another example of the difference between theory and reality I have mentioned before.  You are catching onto the mechanics and applying them well.

I hope this was helpful.

Travlin