The Matrix Of The Financial System What pill would you
take?
By Melvin J. Howard
After seven years of the most accommodative monetary
policy in U.S. history, the Fed on Wednesday, as widely expected, approved a
quarter-point increase in its target funds rate. The new target will go from 0
percent to 0.25 percent to 0.25 percent to 0.5 percent. Most members expect the
new rate to coalesce around 0.375 percent before the next hike, according to a
chart showing individual member expectations.
The decision, given the official stamp of approval
from the Federal Open Market Committee, marks the first increase since the
panel pushed the key rate to 5.25 percent on June 29, 2006. In a succession of
moves necessitated by the financial crisis and the Great Recession that
officially ended in mid-2009, the FOMC took the rate to zero exactly seven
years ago, on Dec. 16, 2008. Let’s go back to 2008 when the FED needed help
that’s right. The Federal Reserve System the central banking system of the
United States needed help.
The Treasury Department, for the first time in its
history, sold bonds for the Federal Reserve in an effort to help the central
bank deal with its unprecedented borrowing needs. The Treasury set up a
temporary financing program at the Fed’s request. The program auctioned
Treasury bills to raise cash for the Fed’s use. The initiative was to help the
Fed manage its balance sheet following its efforts to enhance its liquidity
facilities over the previous few quarters. Normally, the Fed issues Federal Reserve Notes for
U.S. bonds (the federal government’s I.O.U.s), in order to provide Congress
with the dollars it cannot raise through taxes. Now, the government is issuing
bonds, not for its own use, but for the use of the Fed. The plan was to swap
them with the banks’ junky collateral directly, without actually putting them
up for sale to outside buyers. As stated in its press release dated March 11,
2008.
Federal
Reserve Actions
The Federal Reserve announced an expansion of its
securities lending program. Under this
new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up
to $200 billion of Treasury securities to primary dealers secured for a term of
28 days (rather than overnight, as in the existing program) by a pledge of other
securities, including federal agency debt, federal agency
residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated
private-label residential MBS.
The TSLF
was intended to promote liquidity in the financing markets for Treasury and other
collateral and thus to foster the functioning of financial markets more
generally. As is the case with the current securities lending program,
securities will be made available through an auction process. Auctions were held
on a weekly basis, starting in March 27, 2008.
The Federal Reserve consulted with primary dealers on technical design
features of the TSLF.
In addition, the Federal Open Market Committee authorized
increases in its existing temporary reciprocal currency arrangements (swap
lines) with the European Central Bank (ECB) and the Swiss National Bank
(SNB). These arrangements provided
dollars in amounts of up to $30 billion and $6 billion to the ECB and the SNB,
respectively, representing increases of $10 billion and $2 billion. The FOMC
extended the term of these swap lines through September 30, 2008. These actions
y supplement the measures announced by the Federal Reserve the week before to
boost the size of the Term Auction Facility to $100 billion and to undertake a
series of term repurchase transactions that cumulated to $100 billion.
To switch debt that is less liquid for U.S. government
securities that are easily tradable” means that the government gets the banks’
toxic debt, and the banks get the government’s triple-A securities. Unlike other debt, federal securities are considered “risk-free” for
purposes of determining capital requirements, allowing the banks to improve
their capital position so they can make new loans.
But here is something more interesting October 3,
2008, the Fed acquired the ability to pay interest to its member banks on the
reserves the banks maintain at the Fed. As reported by Reuters: “The U.S.
Federal Reserve gained a key tactical tool from the $700 billion financial
rescue package signed into law on Friday that will help it channel funds into
parched credit markets.
Tucked into the 451-page bill is a provision that lets
the Fed pay interest on the reserves banks are required to hold at the central
bank. To put it simply if the Fed’s money comes ultimately from the taxpayers,
that means the taxpayers are paying interest to the banks on the banks’ own
reserves – reserves. Now where does that money go? Let’s take a look how the
Treasury and the Fed interact with each other. 1) What role does the Treasury
Department play? - It is the role of the Treasury to make sure that the U.S. government
has enough money to fund the obligations of the U.S. government. Whether the
government is running a fiscal surplus or deficit, it is their responsibility
to determine how much money should be raised and when. It is also their
responsibility to determine what the maturities of this debt should be.
The amount of each offering is set by the amount of
debt maturing (thus requiring refinancing) as well as any additional debt that
may be needed above and beyond that (i.e. to fund that year's deficit). If you
check, this is done thru weekly Treasury bill auctions, quarterly refundings
and other periodic treasury auctions such as the monthly two-year note.
Treasury does not conduct these auctions. The Federal Reserve Bank of New York
thru their network of recognized government securities dealers conducts them.
The important thing to note here - these Treasury financings has absolutely no
impact on the money supply. They simply
determine how much Treasury debt is outstanding (i.e. the national debt).
(2) What role does the Federal Reserve
play - Besides facilitating the Treasury's effort to fund the operations of the
government, the FED is charged (along with many other things) with determining
how much money is in the system. So how
does the FED expand or contract the money supply. To create more money, they
buy a Treasury bill, note, or bond from one of the recognized government
securities dealers (i.e. $1MM treasury security goes to FED, $1MM is released
into the system as payment). It’ the
money creation/contraction (that can be raised or lowered at will by the FED
simply by buying or selling treasury or GSE agency securities), that then gets
circulated throughout the financial system.
The National Debt now exceeds $18.7 trillion dollars.
In Fiscal Year 2006 the U.S. Government spent $406 billion on interest payments
alone to holders of that debt. Why so big a debt? Because Government spends far
more then it receives in revenue. In 2007 the US government paid roughly $430
billion in interest to pay for money borrowed to finance previous deficits.
Each year it keeps getting rolled over the cycle continues. So how does it do
this year after year without the financial world coming crumbling down?
Here is how for example, the government runs a $400-billion-dollar
deficit. The Treasury Department has to sell $400 billion in US Treasury bills,
bonds and notes (government IOUs) to buyers at a rate of interest sufficient to
attract their money (and beat the interest competition of other banks’ CDs and
other governments’ bills, bonds and notes). To avoid a credit squeeze, the
Federal Reserve System Open Market Committee in Washington directs the NY
Federal Reserve Bank to purchase roughly 10% of that total (or $40 billion) in
existing US bills, bonds, and notes from the current holders. To pay for them
it creates the $40 billion out of computer entries. Now this new $40 billion is
deposited into the banks of the various bill, bond, and note sellers, thereby
increasing the reserves of those banks by $40 billion still with me? Pursuant
to the Federal Reserve Act of 1913 those banks must keep only 10% of those new
deposits on "reserve." (Because these banks do not have to keep 100%
on reserve, this banking system is called a “fractional reserve” system.).
So of the $40 billion deposited, the banks must keep
10% on reserve ($4 billion) and may loan out $36 billion (90%), for business
loans, mortgages, credit card loans, to purchase government bonds - for
whatever borrowers want. Those loans (and payments) are in turn deposited in
banks. So of the $36 billion loaned out and then re-deposited, the banks
receiving the new deposits can then loan out 90% or $32.4 billion, retaining
10% or $3.6 billion as reserves. Then wash and repeat the same process every
year.
The events of 2008 exposed the flaw in the system the
money supply was cut off people lost confidence in the dollar. What happened as
a result, stocks declined in value some almost by 50%. Corporate bonds were
defaulting. Loss of confidence caused a flight of capital from U.S. government
securities. Real estate prices plummeted the U.S. dollar had lost some of its
purchasing power.
So just like in the film the Matrix, Morpheus who by
the way is (named after the Greek god of dreams and sleep). Asked Neo here are two pills. The red pill
will answer the question "what is the Matrix?" (by removing him from
it) and the blue pill simply for life to carry on as before (not knowing
anything more). As Neo reaches for the red pill Morpheus warns Neo "Remember,
all I'm offering is the truth. Nothing more." About 90% of the population
thinks that life is just the way it is and don’t want to learn or question the
status quo. Then I guess the blue pill is for them. But for the other 10% of
the population we are in the know. So the question I leave with you is this
what pill would you take if you really wanted to know how the banking system
works? You take the blue pill, the story ends and you wake up believing
whatever you want to believe. You take the red pill, you stay in wonderland and
I show you just how deep the rabbit hole goes!
