Fed Creates Bank Margin Squeeze

This could turn into the mother of all interest rate margin squeezes for the banks now that the Federal Reserve has announced that for the first time in its history, it has a established a “target range” for the fed funds rate of “0 to 0.25%.” And the FOMC “anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

How can banks make money with an anticipated lowering of the prime rate to 3.25% when their cost of funds with any kind of intermediate term duration will likely be equal to or greater than that amount? And how will money market funds remain afloat? Once again, the Fed has demonstrated its failure to factor in all the repercussions of its actions that only cause further economic harm.

If banks lower their prime rate to 3.25% and the cost of funds for a matched book of intermediate term loans (say 5 to 7 years) would be that amount or greater, banks would be forced to support the prime rate with a drastically unmatched book. Basically, it means borrow short and lend long. This is the formula that history has taught us is disastrous: borrowing short term at extremely low interest rates that are not sustainable and loan margins turning negative as soon as the Fed needs to start fighting inflation.

Now that we understand the banks formula for failure, will there be any benefits for businesses and consumers? It is likely that banks will price loans based upon the anticipated cost of funding over the life of the loans and the credit risks of the borrowers. No matter what the Fed sets rates at, no bank will lend to a customer who can’t pay the money back - especially if they have no opportunity to sell bad loans.

The Fed voted to pay 0.25% on required and excess reserve balances held by financial institutions at the Fed, so the FOMC could have just as easily stated that they lowered the Fed funds rate 75 basis points from 1% to 0.25%. (Since there would be no reason for a bank to lend Fed funds at a price lower than it can get from the Federal Reserve itself.)

Savers and people living on a fixed income, pension plans, and insurance companies should not view this as a holiday treat from Helicopter Ben. You can’t solve the economic crisis by attempting to recreate the conditions that caused the crisis in the first place. This is why Ben Bernanke needs to go. NOW.

Comments

[TimT:]

Good article. Lower rates don't help state and local banks that are the only ones doing any lending right now. The rate cut is more welfare for the big banks that helped get us in the mess in the first place.

With regard to the Fed announcement yesterday...

I thought the "short treasury trade" would be the trade of the century but after I read the Fed Statement yesterday and saw that they were going to buy treasuries, I put that idea on hold.

What really puzzles me is that the Fed has been doing everything so far to put money in the system and increase money supply to "get the economy moving again." The after effects of this action would be inflationary in the long run and therefore begin to weaken the dollar. This weaker dollar anticipation would then cause foreign debt holders of Treasury Securities (mainly the Chinese, to the tune of $500bln) to want to sell their positions. With the Fed announcement yesterday it appears the Chinese and others now have a way to sell their positions at a profit and have a ready, willing, and certainly able party (the Federal Reserve Bank--read cost to taxpayers) to maintain the high price as they sell. I am beginning to think the Fed has no clue--they appear to be "academic" only with no real world pragmatism or understanding of what our situation is with regard to our free trade with the rest of the world without any protections for our hard faught for economy, standard of living, and way of life. Don't people understand that when we open trade with other countries and the trading partners we buy from don't float their currency, we in effect import deflation? I'm for free trade but lets have some rules. Too late now...

They say that if your not a little paranoid you don't really know what's going on. What I'm seeing happen over a matter of 4 months is litterally a financial coupe d'etat takeover of our country. Who is behind it and who will end up with what, I have no clue. All I can say is the middle class is getting clobbered.

2008 Dec 17 10:19 AM

[Smarty_Pants:]

Big Wall Street banks can now borrow from discount window at no more than 0.25% and invest the same money in long bonds at 3+%. Short term discount loans can be rolled over indefinitely at FED, interest differential will build up bank equity over time until the long bonds mature.

In essense, it is a -3% interest payment to the banks on borrowed money, ie. a free gift of taxpayer money to the banks disguised as interest rate arbitrage. It also keeps most of the freshly printed money out of circulation for a while.

Everybody wins, except the taxpayer, which is what you might expect from any gub'mint program.

2008 Dec 17 11:58 AM

[flow5:]

"first time in history" -- better check your facts

2008 Dec 17 03:58 PM

[flow5:]

2008 Dec 17 03:59 PM

[Xorthfred:]

Disagree. The lower fed funds rate lowers the cost of capital for banks, which are not lending any money at Prime anyway. Credit default swaps for lending to Berkshire Hathaway reached 600 over treasuries, so don't tell me that banks are lending money to borrowers at the Prime rate-maybe LIBOR +Prime+two but not Prime.

2008 Dec 17 04:15 PM

[M dub:]

Still trying to get my head around some of the point here. What does the prime rate have to do with a bank's lending model? Sure, some credit cards and heloc assets are still prime based, but most dollar banking is still libor driven. The curve is what it is, which is mostly due to quantitative easing on the long end, so dropping the front end makes a lot of sense to keep the curve upward sloping. The fed wants consumer rates down either way, for lower debt service to spur the economy. Banks have too many existing assets on the books and the fed is backstopping their funding, but they don't want new assets anyways. Sure, it screws fixed income folks but so would a depression.

The inflation and dollar comment are valid, and this has been the case for quite a while. Desperate depression avoidance, which has serious inflation/paper currency consequences.

Re the chinese: their investment is now pfd. equity....the only buyer of UST now is the fed so they will know if the Chinese are trying to unwind their positions (i.e not gonna happen). So all we need is new money.

Re: Money markets: The government is everything right now. There are no real "money markets", it's all fed and treasury risk now, which i don't think changes from 1% to .25% or lower.

Banks aren't going to lend but they weren't at 1% either, so again, the fed already said they will originate residential mortgages. The banks are irrelevant anyways, there is one relevant balance sheet.

So what is the point about the prime rate since its mostly there for perception? I think whats happening in the libor markets and mortgage markets is more relevant.

2008 Dec 17 04:30 PM

[TimT:]

Interesting comment about the Feds position now being the only buyer of Treasuries and therefore in a position to know if Chinese are unwinding. I never thought of it that way. Are you sure the chinese are mostly in Pfd's. Suggestions on where I/we could find out the facts about it?
On Dec 17 04:30 PM M Dub wrote:

> Still trying to get my head around some of the point here. What does
> the prime rate have to do with a bank's lending model? Sure, some
> credit cards and heloc assets are still prime based, but most dollar
> banking is still libor driven. The curve is what it is, which is
> mostly due to quantitative easing on the long end, so dropping the
> front end makes a lot of sense to keep the curve upward sloping.
> The fed wants consumer rates down either way, for lower debt service
> to spur the economy. Banks have too many existing assets on the books
> and the fed is backstopping their funding, but they don't want new
> assets anyways. Sure, it screws fixed income folks but so would a
> depression.
>
> The inflation and dollar comment are valid, and this has been the
> case for quite a while. Desperate depression avoidance, which has
> serious inflation/paper currency consequences.
>
> Re the chinese: their investment is now pfd. equity....the only buyer
> of UST now is the fed so they will know if the Chinese are trying
> to unwind their positions (i.e not gonna happen). So all we need
> is new money.
>
> Re: Money markets: The government is everything right now. There
> are no real "money markets", it's all fed and treasury risk now,
> which i don't think changes from 1% to .25% or lower.
>
> Banks aren't going to lend but they weren't at 1% either, so again,
> the fed already said they will originate residential mortgages. The
> banks are irrelevant anyways, there is one relevant balance sheet.
>
>
> So what is the point about the prime rate since its mostly there
> for perception? I think whats happening in the libor markets and
> mortgage markets is more relevant.
>

2008 Dec 17 06:18 PM