How the Fed Is Making Banks Lend

The Federal Reserve is forcing banks to lend or face financial disaster. The Fed’s latest strategy gives banks the stark choice of lending or losing a lot of money from operations.

Everyone knows the Fed cut its target Federal Funds rate to the bone this week. In a less obvious move, the Fed is also forcing down rates on Treasury bonds and other securities. As a result, banks have the choice of buying bonds that yield less than their cost of funds or lending. Any bank that decides not to lend will suffer losses. Cash is trash and if banks don’t recycle it, they will slowly bleed to death.

The Federal Reserve is returning banks back to the lending business in two ways.

First, the Fed is providing banks with cash to lend by dramatically increasing money supply. Newly created money becomes new deposits in banks. For the last 3 months, money supply as measured by M1 increased by an astonishing annual rate of 37.6%. The largest components of M1 are cash deposits at banks and those components are growing very rapidly. The Fed is making sure that banks get A LOT of new cash to lend.

In normal times, banks gather cash by accepting deposits and then recycle their cash into loans. But, these aren’t normal times and banks aren’t reacting the way they have in the past. Instead of recycling cash into loans, banks have tried to avoid risk by recycling their cash into low risk bonds that are like cash equivalents. So, monetary easing didn’t really do anything for the economy because cash was recycled into cash look alike instruments rather than into loans. The banking sector’s huge demand for cash equivalent investments caused yields on short term Treasury and government securities to drop to almost 0% (and was even negative for brief periods of time).

This led the Fed to its second, less obvious, strategy. The Fed has starting purchasing the cash equivalent investments that banks are buying and in the process driving down yields. Banks are losing money on their formerly safe investments because their all-in cost of deposits is higher than the yield they are earning from cash equivalent investments. This is similar to a retailer buying inventory for $100 and then selling it for $95. It isn’t a good business strategy. To make a positive net interest spread between their all-in cost of deposits and their investments, banks are being forced to lend. Loans to businesses and consumers have high enough yields for banks to make a profit.

Even when banks pay 0% interest to depositors if they don’t lend money they will lose money. Banks have a marginal cost of holding deposits that is much higher than the interest cost of 0%. Bank deposit costs include: operating expenses, FDIC insurance, cost of equity and regulatory compliance costs. These costs are generally between 1% and 3%. And if banks accept deposits that are CD’s which have an interest rate of between 1.5% and 4.5%, their all-in cost of funds gets even higher.

The types of investments that the Fed is initially targeting to drive down yields include Treasury securities, Federal Funds, Agency bonds and Agency and government guaranteed mortgage backed securities. These investments have historically been considered low to no risk investments that are as good as cash. One by one, the Federal Reserve is going to take away the hiding places that banks have used to avoid lending.

While yields on low risk cash equivalent investments are around 0%, the rate of interest that “real” borrowers need to pay for new loans has remained high. Most real measures of loan availability for businesses and consumers indicate a continuing credit crisis, incredible risk aversion and a relatively high cost of borrowing. It is into this lending void that the Fed is driving banks.

However, if banks continue to avoid lending to businesses and consumers, the Fed is making sure that they will feel a lot of financial pain. The Federal Reserve has put banks between a rock and a hard place. Either they lend, or destroy their institution with a negative interest spread and risk regulatory discipline. The Federal Reserve has morphed the strategy of hoarding cash equivalent investments into a very risky decision.

The Fed’s innovative approach goes far beyond the “qualitative easing” that bankers and economists were expecting. Sometime in the next few weeks, after corporate planning staffs and consultants grind out models and analysis, it is going to dawn on bankers that they have to participate in the economic recovery by lending. The Fed’s two-pronged strategy will get banks lending again. And, with fiscal stimulus from the new Obama Administration, the economy will respond sooner than most people expect.

Comments

[SugarDaddy:]

You make great points, however the banks reluctance to loan coupled with people around here who are shell-shocked at the thought of new debt is staggering. If the rates to refi are low enough, maybe things will get going, but at what price ?

2008 Dec 20 12:40 PM

[Philly Jim:]

Great article! Maybe the decoupling theorists will have learned their lesson and put their chins back down after this economic crisis. Don't bite the hand that feeds you. Would you keep feeding your puppy if you knew that one day that puppy would grow-up to kill you? When your asked to allow your products to be sold in another country, and you become rich by selling your products to this country, you don't then threaten this country by developing weapons and destroy satellites and staging military exercises. That's just plain ol' retarded, ain't it?

Next up: The OPEC cartel starring our friend Vladimir.

2008 Dec 20 02:24 PM

[Steven Hansen:]

Mark, great presentation. If the banks lend, at what rate do they lend? what happens if inflation kicks in? - then they will really be between a rock and a hard place. the banks have to know inflation is not coming.

2008 Dec 20 08:01 PM

[icandoitdon:]

great article. a correllary to this is that the federal reserve is also forcing consumers into more risky investments, since accepting a negative real return on short term investments is akin to stuffing your cash in a mattress.

i think the fed's strategy is doomed to fail because banks cannot lend to overleveraged consumers who are unwilling to take on new debt. the genesis of this problem was excess leverage. instead of policies designed to mitigate the effects of the unwind, the fed is attempting to keep that ponzi scheme going to an unwilling, debt-burdened public. "fixing" housing prices by lowering the cost of funds, for example, is not going to create the kind of demand for housing that lower prices would.

what's nice about capitalism is that most problems will fix themselves...it is self balancing. we have a federal reserve that thinks it can do a better job. i think they're absolutely wrong.

pay me now or pay me later...but the fed is nuts if they think there won't be a heavy price to pay for any market-distorting option they choose to employ...

2008 Dec 20 08:59 PM

[jepittman:]

The banks lend at a rate higher than their cost of funds. The higher the better. Inflation will take many quarters to start kicking in. By then the rates will be rising and banks will gradually roll up the average yield of their loan portfolios by replacing older, lower yielding loans with newer higher yielding loans.

The author makes a compelling case for an economic recovery. As long as the new loans are made to quality borrowers the recovery should be a sustained one. Hopefully the banks have learned their lessons.


On Dec 20 08:01 PM The hand wrote:

> Mark, great presentation. If the banks lend, at what rate do they
> lend? what happens if inflation kicks in? - then they will really
> be between a rock and a hard place. the banks have to know inflation
> is not coming.
>
>

2008 Dec 20 10:13 PM

[icandoitdon:]

two non sequiturs here:

quality borrowers
banks have learned their lessons

you must be joking.


On Dec 20 10:13 PM jepittman wrote:


> The author makes a compelling case for an economic recovery. As long as the new loans are made to quality borrowers the recovery should
be a sustained one. Hopefully the banks have learned their lessons.
>

2008 Dec 20 11:02 PM

[jepittman:]

Hardly. There are ample 'quality' borrowers out there who are just scared right now. Add the frightened loan officers and loans just are not being made. Everyone needs a little time to go by for emotions to settle down. Bankers who have 'learned their lessons' have raised credit standards enough so that more than a pulse is necessary to qualify. Poor lending standards contributed a lot to the mess we made. Reasonable lending standards to quality borrowers by motivated banks will reignite the economy, as the author says, sooner than most expect.


On Dec 20 11:02 PM icandoitdon wrote:

> two non sequiturs here:
>
> quality borrowers
> banks have learned their lessons
>
> you must be joking.
>

2008 Dec 20 11:19 PM

[investor88:]

Logical article, if the logic is carried through then ka-boom! all problems solved and the merry debt binge starts again. Sometimes things may not be so clear cut, the stock market is promising but better to monitor further?

2008 Dec 21 07:26 AM

[fatcat:]

Affordability of housing remains a big issue for the intermediate term...even 2% loans wouldn't solve many borrowers problems.

Great article by Mr.Sunshine....

2008 Dec 21 08:59 AM

[Asbytec:]

Great article, thanks for the additional insight. I hope it works.

But, as was said above, is a bank gonna weigh risk of mortgage default or lose cash? They are between a rock and a hard place.

Need to digest this some more. If a recovery is likely sooner than I imagine, I'll gladly eat crow.

2008 Dec 21 10:43 AM

[John Lounsbury:]

One problem the banks still have to get over: how much equity is needed on the balance sheet to retain solvency? This has not been sorted out yet. If a bank is faced with the following choice,

1. Make loans and prevent taking a smaller operating gain (or even a loss, if small) OR

2. Retaining capital and remaining solvent,

which will they choose?

It may take longer than seems at first glance to have this Fed policy take hold.

Uncertainty is what makes a horse race interesting.

2008 Dec 21 11:00 AM

[Joyful Alte...:]

The commenters seem to be stressing consumer borrowing, which may be declining in the near term, and home mortgages, which surely will be down for a while. But what about business borrowing? We have solid businesses and government entities in my area that can't get bank lenders to climb out of their vaults and do business.

I do hope the author's analysis holds, because we'll never steady this economy without sensible bank lending.

2008 Dec 21 11:04 AM

[icandoitdon:]

i'm afraid you don't get it.

credit junkies have been the driving force behind our consumer-based economy in recent years. quality borrowers do not rely on debt to finance a lifestyle they can't afford. if you expect them to take up the slack you're mistaken.

the credit junkies who have been shut out of the credit markets, as they should be. at the margin, this will put a drag on the economy for years to come.


On Dec 20 11:19 PM jepittman wrote:

> Hardly. There are ample 'quality' borrowers out there who are just
> scared right now. Add the frightened loan officers and loans just
> are not being made. Everyone needs a little time to go by for emotions
> to settle down. Bankers who have 'learned their lessons' have raised
> credit standards enough so that more than a pulse is necessary to
> qualify. Poor lending standards contributed a lot to the mess we
> made. Reasonable lending standards to quality borrowers by motivated
> banks will reignite the economy, as the author says, sooner than
> most expect.

2008 Dec 21 11:42 AM

[henarl:]

First off, once a credit junkie - always a credit junkie. Given an opportunity, these junkies will borrow to the hilt to continue living beyond their means. It's the American way! Credit card defaults will cure the banks of supporting this stupidity much longer.
Next: Banks, credit unions, mortgage brokers, etc. were able and eager to make home loans to the barely breathing because they could then sell them to the securitizers over and over thus generating initiating fees and not having to worry about credit worthyness. That game is over and these lenders don't yet want to worry about keeping the loans they make. Maybe someday we will get back to lenders keeping the loans they make but until then the mortgage credit markets will remain frozen.
Finally: Business loans are the best hope for a return of money velocity but until the current massive layoffs and business failures subside, don't look for much of that in the immediate future either.

2008 Dec 21 01:35 PM

[flow5:]

"In normal times, banks gather cash by accepting deposits and then recycle their cash into loans"

This is absolutely false. Never are the commercial banks intermediaries in the lending process.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) & (every person), (except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs) -- somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

2008 Dec 21 02:29 PM

[acudoc:]

One minor, teensy, weensy little question: since in our glorious, debt-based monetary system in which currency is created ONLY by people or enterprises going into debt to the private banking cartel who create the medium of exchange ex nihilo, what happens if no one wants to go further into debt?

Whoops.

But by all means, continue re-arranging deck chairs on the Titanic.

2008 Dec 21 02:41 PM

[Kunst:]

Right. The economic model we have lived with for decades, where consumers use debt to buy more than they can afford, is dead. The only debt that makes sense now is debt that saves the borrower money or finances a real asset. Right now, people are holding off on buying assets, real or not. The only people who want to borrow are the ones who are already in financial trouble, hardly an enticing customer for the banks.

2008 Dec 21 03:14 PM

[ChrisCD:]

The problem I see is the Fed's plan is relying too heavily on Debt. This Country needs to have some major retractions so that it can return to having a majority living within their means and not being leveraged out the wazoo.

The Fed should be supporting smart lending and saving.

2008 Dec 22 02:02 PM

[jepittman:]

I 'get it' that expectations among market participants (or ex-participants as the case may be) are at lows not seen in a generation. I 'get it' that pessimism is highest near market and economic lows. I 'get it' that economic incentives always have and always will induce action in the direction of economic gain. I 'get it' that banks are sitting on ONE TRILLION DOLLARS of excess reserves that they cannot earn a return on unless they lend to retail borrowers. As another poster above has correctly observed old habits die hard. The 'credit junkie' as you derisively call consumers will be back. Slowly perhaps at first, and quite likely less aggressive as he has been in the past, but he is going to own a car, buy clothes for his wife and children, take his family out to eat, take his summer vacation to the beach, and in general continue to live his life more or less the way he has in the past. There is currently no shortage of people on these boards who believe this country is the economic equivalent of Bolivia and that all debt is evil and will destroy its owner, and that borrowers are all crooks out to get something for nothing. These people are entitled to their opinions but with all due respect they do not understand how modern economies function.




On Dec 21 11:42 AM icandoitdon wrote:

> i'm afraid you don't get it.
>
> credit junkies have been the driving force behind our consumer-based
> economy in recent years. quality borrowers do not rely on debt to
> finance a lifestyle they can't afford. if you expect them to take
> up the slack you're mistaken.
>
> the credit junkies who have been shut out of the credit markets,
> as they should be. at the margin, this will put a drag on the economy
> for years to come.

2008 Dec 22 02:23 PM