Ok I have been research for ten hours and I doubt I will ever understand the Federal Reserve so I am hoping someone can help me. From what I can tell this is what I think I understand. I would really like it if someone could correct me(note the figures of 1000 and 1050 are simply arbitrary). Say for example the government needs a thousand dollars. The government will give a security bond to the Federal Reserve. The Federal Reserve will charge interest on the bond(lets say the price is simply 1050 for demonstration purposes). The Federal Reserve creates 1000 dollars and gives it to the government. The Fed now has 50 dollars that the government owes it and 1000 dollars for the bond. The Fed can now create approximately 1050 dollars. The Fed gives the bond out to banks who buy the bonds at 1000 dollars and sell it back to the Reserve for 1050. The Fed is creating money twice in this scenario(one time to give to the government and the other time to give to the bank). Am I right on this or severely wrong? If I'm wrong can someone please explain?
The Fed either buys bonds directly from the Treasury or from the 'private' sector who bought them from the Treasury.
If the Fed sells bonds in its possesion it removes money from the system and if it buys them it creates new money for either government deficit spending or for central bank reserves that the banks dutifully pyramid off of.
The two are completely separate and only have the commonality in that government debt is involved. The Fed can create new money by buying any old thing and writing a check on itself since the only way to cash it is for it to eventually end back up at the Fed. This increases the banks reserves and causes inflation.
When banks buy government debt straight from the Treasury there is no new money being created so when the Fed buys it through open market operations it isn't creating money twice.
My impression on how the interest gets paid on the bonds is they sell it at auction at a discounted rate to reflect the cost of borrowing money like a $1000 bond will sell for $900 and will 'pay' 10% interest over its life. Haven't really looked into it too much but I'm pretty sure how that works.
I have my own blog at FSK's Guide to Reality. Let me know if you like it.
Ok so using your example. The Federal Reserve buys a bond that the government sold that will eventually mature to 1B. The Federal reserve creates 999M which is the face value of the Treasury Bond. If the bank does not increase profit, why would they buy a bond only to sell it back to the Fed? Furthermore, how does the bond get it to the bank? Does the Fed sell it to them or the government directly?
The Federal government does not sell bonds directly to the Federal Reserve. The Federal government only sells bonds to banks and the general public.
However, the Federal Reserve may then buy the bond immediately after the government sells it. For all practical purposes, the Federal government is selling about 10% of its debt directly to the Federal Reserve, although it's through the middleman of a bank. Reserve ratios are 10x. For each $1 the Federal Reserve creates, another $9 may be created by the financial industry.
What does the bank get out of this arrangement? Suppose the bank starts with $10M in cash. Suppose that, when investing in Treasury debt, leverage ratios of 100x are allowed. Leverage ratios are not the same as reserve ratios. A 100x leverage ratio means that for each $10M in net worth, the bank can buy $1B total in Treasury Bonds, borrowing the remainder from the Federal Reserve.
Suppose the Fed Funds Rate is 2% and the Treasury Bond yields 2.2%. The bank puts up $10M of its own money. The bank gets $990M from the Federal Reserve, borrowing at the Fed Funds Rate directly from the Federal Reserve or borrowing from other banks. The bank buys the $1B bond from the government, earning a profit of 0.2% times 100x leverage for a total profit of 20%.
The bank made a guaranteed riskless profit.
I can't do this trade myself, because I can't borrow at the Fed Funds Rate. Banks are guaranteed a certain profit, built into the rules of the monetary system.
Also, the above calculation assumes the Fed Funds Rate never changes. Replace "average future rate" with "current rate" if you expect the Fed Funds Rate to change.
Yes, but I thought you said that the Federal Reserve will buy back the bond before it matures. So if the bank has 10M and they borrow 990M. The bond eventually has to mature at a rate of 2.2% for them to make a profit. The bank has borrowed at 2%. If the banks sell the bonds before they can mature at 2.2% how are they making a profit?
Also can the bank use the the bond as a reserve?
The Federal Reserve only buys back about 10% of Treasury debt before maturity. The rest is owned by banks and individuals.
Bank reserves are always cash (physical Federal Reserve Notes or electronic credits). Bank reserves and assets are different. The Treasury debt does count as part of the banks' assets. Treasury Debt is a "Level 1 asset", because there's a liquid market where they can be bought and sold. The Federal Reserve will always buy Treasury debt if the prices get too low (interest rates get too high).
Reserve ratio = (cash on hand) / (total debts + cash on hand). Reserve Ratio >= 0.1 at all times.
Leverage ratio = (total assets) / (total assets + total debt). Leverage Ratio >= 0.01 at all times. The legal leverage ratio varies by asset class; in this example, I'm using Treasury debt and assuming the legal leverage ratio is 0.01.
Assume banks are allowed to use reserve ratios of 10x. Assume banks are allowed to use leverage ratios of 100x when investing in Treasury debt. Banks will always have the maximum reserve ratio and leverage ratio that the law allows; otherwise, they're not maximizing their profits!
Suppose Bank A has: $1B in Treasury Debt (yielding 2.2%) $1.10B in debt (at the Fed Funds Rate of 2%) $130M cash on hand
The bank has a leverage ratio of (approximately) 0.01. The bank has a reserve ratio of 0.1. The bank has a net worth of $30M. The bank is making a guaranteed riskless profit, because it's borrowing at 2% and investing in debt yielding 2.2%.
Suppose Bank B has the same balance sheet as A: $1B in Treasury Debt (yielding 2.2%) $1.10B in debt (at the Fed Funds Rate of 2%) $130M cash on hand
The Federal government decides to auction another $1B on Treasury debt. Bank A buys. Now, Bank A has a balance sheet of: $2B in Treasuy Debt (yielding 2.2%) $1.10B in debt (at the Fed Funds Rate of 2%) -$870M cash on hand.
Bank A needs to come up with another $1B so in can pay the Federal government and not be violating its reserve requirement rules. What does Bank A do? It borrows from Bank B.
However, Bank B doesn't have enough money to lend Bank A. Oh no! The Fed Funds rate is rising! It's time for the Federal Reserve to "monetize the debt". The Federal Reserve buys $100M in Treasury Debt from Bank B.
Now, Bank B's balance sheet is: $900M in Treasury Debt $1.10B in debt $230M cash on hand.
Bank B lends $100M to bank A.
Now, Bank B's balance sheet is: $900M in Treasury Debt (yielding 2.2%) $1.10 in debt (at the Fed Funds Rate of 2%) $100M loan to Bank A (at the Fed Funds Rate of 2%) (an asset) $130M cash on hand.
Bank A now has $100M, which it gives to the Federal government. The Federal government immediately deposits this cash in its account at Bank B.
Bank B now can loan another $90M to Bank A. Bank A pays this $90M to the Federal government. The government deposits this money in its account at Bank B.
Summing up the infinite series, Bank B creates another $900M in new money via fractional reserve banking. In practice, there's a little "wiggle room" in the bank balance sheets, so the whole process occurs in only one step.
At the end, Bank B's balance sheet is: $900M in Treasury Debt (yielding 2.2%) $1.10 in debt (at the Fed Funds Rate of 2%) $1B loan to Bank A (at the Fed Funds Rate of 2%) (asset) $1B in Federal Government's account (yielding 0%) (debt) $230M cash on hand
Bank A's balance sheet is: $2B in Treasury Debt (yielding 2%) $1.10B in debt (at the Fed Funds Rate of 2%) $1B in debt to Bank B (at the Fed Funds Rate of 2%) $130M cash on hand.
Does this help?
FSK which work are you drawing on? Where can one read up on this? I had no idea about the leverage ratio.
-Jon
I cannot be caged. I cannot be controlled. Understand this as you die, ever pathetic, ever fools.
Irenicus' Diaries.
I worked at an options trading firm. "Leverage ratio" is one of the concepts used for allocating capital efficiently. For example, a hedge fund can use 7:1 leverage ratios when purchasing equities. For every $1 in capital a hedge fund has, it can borrow $6 more and buy on margin.
It's the same concept as "borrowing on margin" as an individual investor. When institutional investors "buy on margin" they get to use more aggressive leverage ratios. As an individual retail investor, you are limited to 1:1 leverage ratios (50%).
If you invest in a bank stock, you can carefully read their annual statement and see it.
That's quite the read, thanks. I liked your point that banks get a guaranteed profit, built into the rules of the monetary system
I was wondering: why would bank B ever lend to Bank A? B can lend Bank A money at 2% but get a far better return of 2.2% by buying treasury bonds.
Right, thanks for the explanation. I wonder if any of the Austrian economists have written on this - maybe Huerta de Soto.
I think all of it is way more complicated than I can understand.
Also I think I get it. The example that you gave before was a little more simpler I think. I just didn't know that the Fed was only buying back 10% of loans before maturity. For some strange reason, I just thought it was more close to 100%.