TGIF! This marks my first week home in Michigan for the summer, and while I’m still adjusting to the time change (as are the Kung Fu Kids—they seem to want to go to sleep at 11:30pm or later…8:30pm California time!), it’s wonderful to be home and I’m writing you this missive while looking out at this view:

Beautiful Sunset on the Lake

Yep, it's a rough life...don't hate me!

I hope you’re enjoying your Summer, too (the solstice came this week…lost in the frenzy of Ben Bernanke and the markets’ wild gyrations!).

And speaking of Ben Bernanke, I received a great follow-up question from last week’s inflation QnA from Willis, regarding how the Federal Reserve really conducts these mysterious “POMO’s” and why the banks haven’t lent the money out yet (yeah, what gives?).

I’ll tackle that below and finish with two hilarious YouTube videos (it’s Friday after all!).

Let’s get to it…I’m sure you have plans for your weekend (and I have a gin and tonic to finish!).   🙂

Willis asks: Hi KFG,

In regards to the cash that the Federal Reserve has printed and parked at the bank vaults:

1. Are the bank expected to pay this cash back to the Federal Reserve, or is it looked upon as a total freebie gift?

2. Why hasn’t the banks lent the money out, is it because they are also worried about the inflation effects it may cause?

Thanks for helping us put the pieces of this puzzle together.

Regards,
Willis

Willis, these are great questions. The second one is actually much easier to answer than the first (no, the banks are not worried about inflation—they care only about profits—they can borrow money from the Federal Reserve at 0% and make 16% by turning that money around and buying say, Brazilian sovereign bonds, so why loan it to an American consumer at 4% to buy a house and spur the economy?).

I’ll go into more detail in a minute, but let’s take a look at your first question first.

The short answer is “yes and no”, but since that answer sucks let me explain…

I think a little more diving down into how exactly the Fed conducts these Open Market Operations (POMO’s) is in order.

Here’s how it works:

  1. The Federal Open Market Committee (FOMC) decides on policy, just like it did this week.
  2. The FOMC delegates the implementation of that policy to a specific manager at the Federal Reserve Bank of New York (the NY Fed). This manager oversees the “Trading Desk” of the NY Fed and conducts all of the open market operations on behalf of the Fed.

So how does the Trading Desk conduct these operations, what exactly does it do, and with whom does it “trade”?

Well, the Trading Desk at the NY Fed uses a system appropriately named “FedTrade” and trades with established primary dealers, who are government securities dealers (e.g. U.S. treasury bond dealers) who have developed a trading relationship with the Federal Reserve.

Who are these primary dealers?

I bet you’ll recognize these names… they are of course, the illustrious large financial institutions:

Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.

A fancy definition of these primary dealers comes from the NY Fed website:

“Primary dealers serve as trading counterparties of the New York Fed in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently in open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed’s trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.” — NY Fed

But so what does the Trading Desk trade, and how does it work with these primary dealers?

The Trading Desk does the following:

1. It purchases U.S. Treasury notes/bonds outright from primary dealers by writing a (ahem, bad…) check and depositing it at one or more of the primary dealer institutions.

This is the “freebie gift” answer to your question — this is considered an “uncollateralized purchase” and results in a permanent increase in the primary dealer reserve balances because it is a “buy and hold” operation—the Trading desk simply purchases a bond (e.g. gives the primary dealer a bunch of money for it to keep forever) and holds the bond to maturity.

The primary dealer now has $20 billion (or whatever the number happens to be) more dollars in its reserves, and theoretically doesn’t have to pay it back…it sold an asset (a U.S. government bond) to get this money and the U.S. Treasury is responsible for paying the interest due on the bond.

Poof! Instant money. (Because where did the money come from to write that check? Yep, right out of thin air.)

2. It loans money to the primary dealers in exchange for “high-quality” collateral.

So instead of just outright buying some U.S. treasury bonds from these primary dealers, the trading desk can also simply loan the money to the primary dealer (in which case yes, the primary dealer supposedly would have to pay the money back, because it’s a loan). The trading desk handles both “long-term” (rather funny, considering “long-term” is only 14 days…) and “short-term” (anything less than 14 days, but usually overnight) repurchase agreements, or “repos” for short.

Basically, these are short-term loans used to offset day-to-day fluctuations in the amount of reserves needed by the primary dealers.

So that’s the first part of your question…please let me know if this makes sense or if you’d like a more detailed explanation (it is very confusing, and I believe purposely so!).

As far as why the banks are just sitting on this money and not lending it out…the answer is simply because they don’t need to in order to make money. They are skittish about making mortgage loans after the horrific subprime crisis, and can get relatively “easy money” by investing in other securities and assets sold by other financial institutions and governments (e.g. the Brazilian bonds I mentioned above).

Let me know if this makes sense….I’m happy to attempt to explain further (and I would LOVE to get an infographic created for this—I searched high and low but came up relatively empty today, although I found a few on the Fed itself that I will share with you soon).

But I did find the infamous bears…I love these guys. In the “oldie but goodie” category (these came out around QE2), let’s let the bears explain what the Federal Reserve does with all of its money printing…enjoy!

That’s it for this week…I hope you have a wonderful weekend!

To your financial success,

— Kung Fu Girl