The Fed's Hollowing Out Of US Banks

By: Daniel Amerman | Thu, Apr 29, 2010
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Have the Federal Reserve's unprecedented market and banking interventions fundamentally weakened America's banks? In this article, we will illustrate how the Federal Reserve has been hollowing out the US banking system. We will show how the Fed has been creating a banking industry shell that looks strong on the surface, but is increasingly empty beneath that facade, with less and less economic strength, and an ever greater reliance on the Federal Reserve's monetary creation ability.

Using a single loan as an example, we will explore in step by step detail how almost 10 percent of US bank assets have been hollowed out, with former investments in the economy being replaced by excess reserve balances at the Federal Reserve. On paper, these balances are the highest quality assets which a bank can own, yet in economic reality, they represent an investment in nothing at all.

Few articles explained the dangerous process of creating an almost entirely artificial mortgage market in 2009, and almost none have explored how participating in this process has transformed US banks in 2010. When you finish, you may find yourself looking at the new US banking system in a very different way, as well as understanding the powerful economic and personal investment implications.

A New Mortgage

Let's start by taking a look at a single new $200,000 mortgage that is originated by a single bank. The bank has $200,000 in cash available to lend, where that cash has some connection to the real economy. After all, that's the idea behind the bank: individuals and corporations earn money by producing real goods and services, and they deposit in the bank the money resulting from this real economic activity. Or they use the money to buy a certificate of deposit, or they use the money to make repayments on a loan. Whatever the source for the cash coming into the bank originally, it had some association with the real economy, and is in theory supposed to go back out into the economy, and help support jobs through consumer, mortgage, or business lending.

In the next step, the $200,000 is taken by the bank and is used to make a loan on something that is also entirely real and tangible: the acquisition by a family of a home to live in.

In modern times there's a complication with this mortgage origination. For many years now, banks haven't generally kept these mortgages, but have instead immediately turned them into mortgage-backed securities and sold them into a private secondary market. However, as covered in my article "An Artificial Mortgage Market", a political decision was made in 2009 and early 2010 to keep the private market from determining mortgage rates. The problem was that paying market rates to attract private investors would have meant higher mortgage rates. These higher rates would have meant higher mortgage payments for a given home price, meaning houses would have become less affordable, leading to still lower home prices.

So the government decided instead to support the housing market by creating an artificial mortgage market, where almost all the originations of the most common types of residential mortgages were purchased by the Federal Reserve as soon as the mortgages were converted to mortgage-backed securities. The Federal Reserve had to buy the mortgage security, because the mortgage rates were well below those that would have been available in a free market. This decision to entirely replace the private market on such a massive scale was extraordinary and unprecedented, even if it received very little media coverage and the average person is still unaware what happened.

Where does an effectively bankrupt Federal government running record-breaking deficits get the money to buy the entire mortgage-backed securities market? As covered in my article "Creating 1 Trillion Out Of Thin Air", the government didn't do it directly through the Treasury, nor was this congressionally funded or in the budget. This is a separate and larger intervention than the public banking bailout. What the Federal Reserve did was quite literally create money out of thin air to fund most of its purchases of mortgages. It did this by creating something known as a reserve balance. In our single mortgage example, when the bank sells, it receives a $200,000 reserve balance (deposit) at the Fed as payment for the mortgage.

Banks: The Hollowing Out Process

The results of this process depend on your perspective. Economically, from a bank perspective the real was just replaced with the unreal. The bank previously had dollars that had been associated with the real economy, with real people producing real goods and services, real loans being repaid, and those dollars have now been replaced by dollars quite simply created out of the void, that have no relationship to any economic reality. From an economic perspective - that portion of the bank's balance sheet just disappeared and became purely an obligation of governmental authority.

From a regulatory and accounting perspective the answer is quite different: a deposit with the central bank (which is the Federal Reserve in the United States) is safer than any income-producing asset in the real economy, and is in fact even safer than a US Treasury Bond. For treasury bonds have market risk if interest rates move, while the reserve balances can be redeemed for full value at any time.

What the bank does with each individual mortgage is take money that had at least somewhat of a connection with the real economy, and instead of buying a real asset or lending it out to the real economy, there is a replacement with a phantom asset that didn't exist at all prior to the Federal Reserve creating it from nothingness. (This direct act of creation, in and of itself has nothing to do with concepts like fractional reserve banking, the multiplier effect or the velocity of money - though it can have powerful downstream effects through these very principles.)

Hollowing Out America's Banks

In the big picture, our single mortgage example of a $200,000 loan is not a big deal for a bank with billions of dollars in assets. But that's just the first mortgage. There's the second mortgage, and then the hundredth mortgage, and then the ten thousandth mortgage, and we need to repeat that for every major bank in the US. What we end up with is the Fed having bought well over $1 trillion dollars in mortgage-backed securities, creating an artificial market to support the housing market in the US through 2009 and early 2010.

As of April 7, 2010, according to Federal Reserve statistics, this means that out of about $12 trillion in total assets of US commercial banks, almost 10%, or $1.1 trillion, consists of reserve balances and deposits at the Federal Reserve banks.

What this translates to is that almost 10% of the entire US commercial banking system is no longer directly invested in real assets or the real economy, but in fact consists of assets that have been created out of thin air. Almost 10% of the US banking system has been hollowed out, with the real being replaced by the unreal. That's almost as much as the total $1.3 trillion in US bank equity as measured by US regulatory standards.

The Hole in the US Banking System

Now, that purported equity itself is the result of standards being interpreted in such a way as to lead to as few bank losses as possible in the current environment, meaning that the banking assets created out of the void are in fact likely well in excess of the real equity in the US banking system.

What About The Mortgages?

The preceding was overview of how in the process of creating and funding an artificial market for mortgages for an entire nation, the Federal Reserve has systematically hollowed out the US banking system. Almost 10% of US banking assets, instead of being invested in the real economy, now consist of newly created money that is an unsecured liability of the Federal Reserve. This has been direct monetization on a massive scale that has devastated the economic foundation of the nation's banks, even while on paper it has increased the legal and accounting strength of the same banks.

However, there is another level to the situation. What about the mortgages? The Federal Reserve does have $1.2 trillion in mortgage securities on a vastly expanded balance sheet. Are those mortgages really there as collateral for the bank? Are they perhaps highly desirable collateral, because the banks have the mortgage with the Federal Reserve guarantee not just of principal and interest, but essentially the ability to redeem anytime at par?

If the mortgage purchases were the only iron in the fire that the Federal Reserve had, or the only financial (or economic) problem that this nation faced, there would be more weight to that argument. However, the mortgage crisis is far from the only obligation of the Federal Reserve, and it's far from being the only place where the government is willing to monetize, to create money from the nothingness.

To name a few, the Fed's ability to create money is also likely the eventual source of funding for unsustainable federal government deficits, for financial system bailouts to come, and for future derivatives bailouts. Ultimately, the Federal Reserve is the likely source of repayment for the bailouts of Medicare and Social Security, to the extent these bailouts cost more than taxes can realistically raise. And when the time comes for an already bankrupt US Federal Government to bail the bankrupt states out of their pension fund insolvencies (as well as the Pension Benefit Guarantee Corporation), the Federal Reserve is also likely to be the ultimate source.

What has happened is the banks have replaced direct liens on real economic assets with standing in line to be repaid by the government, along with a long list of impossible government promises. And what we have to keep in mind about impossible promises is - they get broken. One way or another.

Both With & Without Precedents

There's a long history of nations creating money out of the nothingness in times of perceived national need. It's an infamous history. Well-known examples include the continental dollars issued by the US Continental Congress during the Revolutionary war. Other international examples include Weimar Republic Germany, several episodes in Argentina, as well as modern Zimbabwe. Monetization has a very long history. And that history is one of almost always ending badly, usually very badly for a nation's savers and retirees.

There are, however, some unprecedented features to this particular monetization. For 97 years, since its creation in 1913, the Federal Reserve has been able to openly manipulating investment markets by paying banks in reserve balances - but it has never done so. Not in any prior crisis on any significant scale. And there have been plenty of crises, including the Great Depression, World War I and World War II. Yet the Federal Reserve has never resorted to doing this before on a massive scale, and the reason is that for responsible economists (unlike the current Federal Reserve) this is terrifying and risky stuff. When a nation stops worrying about taxes or bonds, and just starts creating money without limit for political purposes - we know what usually happens.

Something else that is unprecedented is the hole that been created with 10% of the nation's banking assets. If the Federal Reserve had just created that money and given it to the banks, and then the banks had done what banks do and lent the money out, then the rapid increase in the money supply would have likely led to rapid inflation. So as covered in my article, "Containing Inflation Via Unlimited Money Creation" there was an act of Congress to allow the Fed to do something it couldn't do before, and that is to not just create reserve balances from the nothingness, but to pay interest on reserve balances. As the Fed could pay interest in new reserve balances, it could always outbid other uses for the balances (if needed), and keep the reserve balances on the bank balance sheets and out of circulation.

As explained by Bernanke himself, and covered in my article, this allows the Federal Reserve to effectively create a corral within which the new money could be contained until the Fed's mortgage portfolios amortizes or can be sold under market conditions. In other words, this is another example of the Federal Reserve deciding it is so brilliant that losses no longer need to be taken due to bad economic conditions if the political results would be unpleasant. The intellectual foundation could be viewed as similar to the mindset that led to the Fed lowering interest rates to create a surging housing bubble that would negate the recessionary effects of the bursting tech stock bubble.

The specifics this time are, however, brand-new. We've never hollowed out the banks before and replaced the equity of the entire banking system with money created out of the void, while carefully corralling the newly created money to keep it out of the general monetary system. It's quite an experiment. After having almost destroyed the US financial system through easy credit and lax regulation, the Federal Reserve decides that it is sufficiently clever to succeed in monetizing without inflation - a prospect that would terrify a merely ordinary central banker. The money is distributed by a secretive Fed to some of the most politically connected insiders in the nation, in a process that has been barely covered (much less understood) by the nation's media. All the limits that previously (somewhat) preserved the value of your savings have been removed - but there is no need to worry. The same people whose dangerous decisions caused this mess in the first place, can be absolutely relied upon to correct it by taking far more dangerous actions!

History & Solutions

Historically, a collapse in the value of a currency necessarily forces a major redistribution of wealth, and the segment of the population that is most devastated by this seems to always be the same. It's the retirees, and the people close to retirement. When we look to Germany, when we look to Argentina, when we look to Russia - it is the pensioners who are impoverished more than any other group.

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Unfortunately, history is repeating itself again. When we look at the headlines about the destruction of retiree investment values, pension assets and so forth, we're really just seeing the beginning. Because the crisis "solution" that is being chosen - creating dollars without the ability to pay for those dollars - essentially represents the annihilation of most of the retirement dreams of the baby boom generation, even if that is not yet recognized. There is not an even cost that is being born by society as a whole, rather some segments are bearing much more of the burden than others. If your peer group (particularly Boomers and older) is headed for disproportionate financial devastation, then happenstance is unlikely to offer a personal way out. Instead, you must take quite deliberate actions to change your personal financial position so that wealth is redistributed to you, rather than away from you.

To get out of step with your generation, and have wealth redistributed to you even as your peer group is being devastated by this extraordinary destruction of wealth, you need to start with an essential and irreplaceable step: education. You need to gain the knowledge you will need to turn adversity into opportunity. This will mean looking inflation straight in the eye and saying: "Inflation, you are likely to play a big role in my personal future, and instead of ignoring you or thoughtlessly flailing away at you - I will study you and your ways. I will learn the deeply unfair ways in which you redistribute wealth, and the counterintuitive lessons about how some investors will be destroyed by inflation and repeatedly pay taxes for the privilege, even while other investors are claiming real wealth on a tax-free basis. I will learn to position myself so that you redistribute wealth to me, and the worse the financial devastation you wreak - the more my personal real net worth grows."

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Daniel Amerman

Author: Daniel Amerman

Daniel R. Amerman, CFA

Dan Amerman

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

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