In Thursday’s (December 17) WSJ, Cato’s Gerald O’Driscoll stated directly that banks were borrowing at the Fed Funds rate and using the proceeds to buy longer term Treasuries. With Fed Funds at .25% and Treasury yields varying between 3.5% (10 yr) and 4.5% (30 yr) this spread is an attractive, low risk, business activity for the banks. The thrust of Gerald’s article was more the crowding out effect (capital going for government purposes rather than private sector/small business purposes) and the article was short.
The focus of this article is what a brilliant strategic move this is for the Fed. The Fed approach of low Fed Funds and banks buying Treasuries has three very beneficial results for the Fed:
1) The strategy is brilliant politically. Give tens of billions of TARP dollars to big name banks/investment banks and you have millions of angry voters ready to take the scalp of any current political office holder. The voters are ready to take these scalps even though it was their checking accounts that were being saved. Operate the discount window that few know exists in an obscure corner of the bond market, and no one is the wiser for the Fed helping out the banks. Banks make the low risk spread over a few quarters and it’s mission accomplished on the Fed goal of strengthening the banking system.
2) This strategy is keeping interest rates low. If mortgage rates go to 7-8%, it’s game over for the housing market. With record bailouts and a lack of resolve to balance the federal budget, the huge new supply of Treasuries seems likely to raise interest rates. What better way to replace the foreign Treasury buyers that are disappearing than have U.S. banks step in and bid at Treasury auctions? Banks since time immemorial have borrowed short and lent long and this Fed Funds spread trade has that risk. If Time’s "Man of the Year" is reluctant to raise Fed Funds, we now see another reason why.
3) The strategy increases bank core capital: The Stress Tests placed great emphasis on Bank Core Capital. Bank Core Capital is a percentage of total bank assets that must be kept in ultra safe investments. When your local bank lends 500k to a new restaurant in town or buys Amazon stock (AMZN) (just kidding, it’s illegal for retail banks to directly own stocks), that is a risky proposition. Neither of those investments counts as Core Capital. Only ultra safe vehicles like cash, deposits at the Federal Reserve and Treasuries count as Core Capital. When banks buy Treasuries, voila!, banks have been strengthened on the objective measure the FDIC and others use to measure the financial well being of banks.
Myself and other long TBT-ers (TBT) have long been wondering why interest rates remained stubbornly low even though the Chinese seem to be coming to their senses. We aren’t facing Financial Armageddon II so we don’t need panic low Treasury rates, and bailouts and huge deficits are creating a huge new supply of Treasuries. The brilliant Fed Funds strategy with banks buying Treasuries may be the reason our TBT investment yield is so paltry.
Two statistics can prove or disprove the themes of this article. First, we need to know who is using and how much they are using the Fed discount window. Second, we need to know whether bank balance sheets show a lot more Treasuries, relative to three or four years ago. This author does not have this data; perhaps someone else can enlighten us?
Disclosure: The author is long TBT and short AMZN.