Busted: Bankers and The Global Economy

February 14, 2008

Fed Auctions: Valentine’s Day from Uncle Sam

commercialbankingaddictioninternet.jpgSince mid-December, commercial banking has had the luxury of using a new anonymous financing tool provided by the Federal Reserve. Previously, banks had been very reluctant to borrow through the standard discount window that the Fed had provisioned. In the eyes of many bankers, using the discount window is a public admission that a bank is in trouble. Too many banks in line for funds could cause public opinion of the banking industry to suffer and the risk of panic. Enter the Fed with the idea that covering the liquidity of U.S. commercial banking could be done in the privacy of the Fed’s own “money pub”.

The word “auction” conjures up images of selling works of art to eager investors at Sotheby’s. In reality, the Fed auction is the means where banks can trade in their risky assets posted on their financial ledgers in exchange for short-term loans from the Federal Reserve. The banks can remove the risky assets from their books and transfer that risk in a “temporary fashion” to the Fed. Naturally, the U.S. government and the national debt covers that risky debt, in effect, posting that risky debt to the U.S. national debt for the “short-term”. In this way, banks receive a fresh infusion of credit that they use to cover and meet their banking debt load requirements. The money can and is used to conduct business as usual and create more loans out of thin air using the wonders of the fractional reserve. If a bank is in really bad shape, it is entirely possible for the U.S. government to get caught holding the “risky debt” as well as the short-term loan.

Under normal circumstances, a bank that faces a liquidity shortage borrows money from other commercial banks. Obviously, the banks must have the funds to loan. Interestingly, this is not the problem. The public admission is that banks have become resistant about lending to one another because of uncertain exposure by other banks to bonds backed by subprime mortgage loans. The reality is that risky internal investment instruments (like SIVs and CDOs) have been created over the last several years. These banking instruments are based on monetary banking theory, created in the hope of boosting profits within the banking industry between brother banks. These internal banking instruments have had a great chilling effect. Since the effect of these internal banking inventions is unknown, the fear is about an unchecked house of cards that banks use to cover their own massive debt. Like the fractional reserve, these internal banking instruments were used to inflate the asset value of the banks that hold them. The reality of these internal instruments may be entirely different from the perception. Because of risk that has been created, bank operate in fear of one another, refusing to take on the risk of dealing with their brother banks.

The Fed auction is new to the United States, but is not new in Europe. When the need presented itself with the mortgage crisis, the U.S. Fed brought this financial tool to the United States. The Fed was looking for more creative ways to address liquidity problems and has found one. Many private economists love the idea of this flexibility in the U.S. commercial banking and finance system. Obviously, the anonymous nature of the auction keeps a few dirty secrets private while exposing the risk quietly across the economy much like the subprime bonds did for global banking. This anonymous transaction could encourage many banks to continue operating in the same ways that brought them to the auction to begin with. The good news is that the auction covers the banks during a major crisis and prevents a series of U.S. banking collapses for the FDIC to clean up. This prevents an embarrassing crisis and loss of confidence in the U.S. banking system. This miracle in financing is considered a “Valentines Day” for the U.S. economy.

Elvis Manning

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