Thursday, December 17, 2009

Banks Not Lending?

A letter:

I have been struggling with figuring out where the banks are getting money to pay back the TARP loans with all the bad loans they have on books and the fact that they are not lending money. I do not see where they are making money suddenly to pay off TARP and pay bonuses!

Thank goodness you got to KPC in time, where ALL can be explained!

The banks are getting money from two sources:

1. The Federal Reserve System, through the its Open Market Desk in NY, and through other outlets, is POURING money into the system, in the form of reserves. Banks, as a result, have an extraordinary amount of cash.

How does the Fed do that? They buy long-term Treasury bonds. Banks can hold reserves in cash or bonds. Many were holding bonds, because there is an inverse relation between interest rates and the value of bonds. If interest rates fall, bond owners take a capital gain. Rates have fallen a lot over the past 14 months. But now rates are near zero. So banks are happy to sell bonds.

When the Fed buys t-bonds, it takes money out of its account at the Treasury (and that account is NOT part of the money supply) and transfers it to the accounts of banks and other entities. Say Fed buys a $1 million dollar bond from Bank of America. BoA has no more wealth than before, but it suddenly has an extra $1 million in cash it needs to invest. The Fed has been increasing the money supply in just this way for the past year or more, at a rate of 10% per month. (I didn't stutter, 10% per month, biggest sustained increase ever, in absolute terms).

2. The assets (collateralized debt obligations and other mortgage-backed securities) have become a little less illiquid. A year ago, nobody would buy CDOs at any price. Now, that part of the credit market has unfrozen a little bit. Banks may still be bankrupt, on their balance sheets, but they can get their hands on some cash, lots of it, by selling off CDOs and other assets.

So, why aren't we seeing the RETAIL credit market unfreeze, since the WHOLESALE credit market, described above, has plenty of cash?

Again, two reasons. First, banks are still trying to avoid risk. And it is not clear that recession is over, in the real world. So banks are borrowing money from the government, at 0%, and then buying NEW federal debt, which pays 3%. That's a guaranteed 3% real return, with no risk. So the Fed buys up debt to increase the money supply, to get the banks to lend. But the banks just buy more government debt, lending to the government instead of lending to small businesses or even large businesses.

And the government is having to borrow more and more to finance the deficit being used to bail out the banks. But the banks are just using the bail-out money to buy more of the debt being used to finance the bail-out! From the taxpayer's perspective, you'd be better off playing the "3-card monte" games in Times Square.

Second, the rush of cash is causing an "asset inflation" which I had always thought was just a wild hypothesis, something that could never happen in the real world. But it IS happening. We aren't getting broad inflation (though the Producer Price Index has been up at a nearly 6% annual rate the last two months!). But the stock market is looking pretty good. But it may simply be because the Austrian Econ prediction of an asset inflation is correct.


Anonymous said...

Borrowing short term at zero and investing in longer maturity bonds isn't risk free-it's only risk free if the duration of the borrowing leg and investing leg match.

I am not saying the risk is big, but instead that the position is not riskfee.

Longer term rates have been rising, no? Doesn't that mean longer term treasuries are becoming less valuable, so these trades may be losing money, depending on maturity.

I would also think that there is a difference between expected inflation and realized inflation. How good a long term hedge are stocks for future inflation relative to long term treasuries? I don't know the answer, but that must be important for your story too.

i have been struggling trying to understand what the Austrians think about the difference between real and nominal rates. They seem to believe that everyone in the economy acts as if nominal rates equal real rates, or that at least the Fed can control real rates through its actions. But maybe you can set me straight, or at least explain the relationship between setting nominal rates and setting real rates...

I am not disagreeing with your post, I just want to understand better the arguments.

Mungowitz said...

Those are good questions, and I don't know the answers.

Two years ago I would have said the Friedman was right about inflation, that it is always a monetary phenomenon, and that inflation is always and only a general rise in the price level.

But the Austrian claim that inflation is really mostly a change in relative prices, directing cash toward the wrong investments, is looking more plausible to me.

Anonymous said...

I have a simple question that seems to be continuously avoided. I notice politicians and pundits seem to be putting the majority of the blame on the banks for not lending. I'm not prescribing this, but it does seem there is an easy political fix to this problem if they really want more loose credit like their rhetoric suggests: they could put a tax on excess reserves. In reality i believe they are actually paying interest on them. What's the deal?

Anonymous said...

That comment on Austrians means that they think that the Fed directly controls real rates?

What are the channels? The new-Keynesian thing is that short term prices are sticky, so nominal rate changes influence real rate changes over short horizons.

What's the Austrian mechanism? Where can I read a concise explanation?

Many current macro-asset pricing models assume that either long-run risk (Bansal and Yaron) or risk-aversion (Campbell-Cochrane) rise during recessions, therefore explaining variation in asset prices and expected returns. Both these explanations are still reduced-form, but at least related to preferences or risk. But what do the Austrians believe?

I want to understand the channels here, not to argue for or against.

Anonymous said...
search this sight for anything you want to know Austrian

King said...

Over what time horizon is base money rising 10% a month? I can get 2.7% for last 12 months, 3.7% last 24. Smaller numbers for M2. I'm using the research data at

I agree with your point on the carry trade against the Fed guaranteeing profits, just wanted to be sure we're using the right data.

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