Are banks running out of good collateral?

The Fed recently published a document under the title: Domestic Open Market Operations During 2007. Innocent sounding enough right? But this doc contains some bad news. Bad News #1: Banks are running out of good collateral. Where's the proof? Everyone, please turn to page 11. Page 11 "Since 2005, average overall TT&L capacity has declined by 13 percent." Ok.... what is TT&L? WIKIPEDIA's semi-technical explanation. (Skip to my explanation if it hurts your eyes.) Treasury Tax and Loan Service is a service offered by the Federal Reserve Banks of the United States that keeps tax receipts in the banking sector by depositing them into select banks that meet certain criteria. Because banks create money (see money multiplier) based on their reserves, if the Treasury were to not redeposit the money they received for taxes, then such payments would either threaten the liquidity of the banking sector, or result in a collapse of the higher monetary aggregates (M1, M2, M3, and L) resulting in deflation. TTL accounts are an attempt to limit the effect of taxation on monetary policy. MY DUMBER EXPLANATION: When people withdraw money from their savings (held in banks) to pay taxes, it decreases the bank's ability to create money dramatically. Remember, for every $10 deposited, the bank can loan roughly $9 to someone else! Woo! But for every $10 taken away, that's $9 less to loan! Boo! To combat deflation and other monetary problems that this mass withdrawal from banks could trigger (low supply of cash/credit results in higher demand, thus higher value!), the Fed deposits the taxes the Treasury receives back into banks using a service called Treasury Tax and Loan (TT&L). It's almost like the money never was withdrawn at all! Yay! So everything remains stable! But that's not all. The Treasury Tax and Loan program also seeks to earn as much interest as possible on public funds (collected via taxes, etc.). For efficiency reasons they try to maintain a balance of 5 billion at all times. Anything more than 5 billion they loan out to banks who pay interest on the loans. If they have less than 5 billion at anytime they call previous loans back from banks. TT&L has several parts. These parts are merely methods the Treasury uses to loan money out to banks. (Skip to the summary if the following specifics are too painful)

====START OPTIONAL READING==== SDI Special Direct Investment. When Treasury balances are unusually high, SDI allows banks to get "cash" from the Fed by using student loans, commercial loans, and one-to-four family whole mortgages retained on the premises of the institution/bank as collateral. TIP Treasury Investment Program. TIP is used to track Main Account and Special Direct Investment (SDI) account balances (both bank's and the Treasury's), monitor collateral pledges, and invest and call Treasury balances (move funds out of or into banks). The whole idea behind TIP is data collection and efficient investment of a surplus. A surplus occurs whenever the Treasury balance exceeds 5 billion. If a shortfall occurs, the data helps them call money back to restore the balance to 5 billion. TIO Term Investment Option. TIO addresses how the interest rate on Treasury balances at private depository institutions should be determined. It provides competitively determined interest rates (through auctions) and offers greater certainty about the length of time fund will be left on deposit. http://www.fms.treas.gove/tip/ - You can see the auction results of the last few years here. ====END OF OPTIONAL READING=====

SUMMARY: TT&L is a cooperative effort of the U.S. Treasury and the Federal Reserve System that has 3 objectives. 1. Dampen fluctuations in bank reserves. 2. Process federal tax payments 3. Earn a market rate of interest on investments of public funds (accrued through taxes, etc.) MY DUMBER SUMMARY TT&L's purpose is to: 1. Stop deflation and other problems that could result from large flows of cash out of banks during tax time, disasters (anything that would make lots of people remove funds from their banks around the same time)

2. Process federal tax payments. 3. Get as much interest on the money available in the Treasury account as possible. Make banks compete for it! Back to the report though... "Since 2005, average overall TT&L capacity has declined by 13 percent." So... if TT&L "capacity" has declined what does that mean? Better yet, what does capacity mean in this context? ELECTRONIC CODE OF FEDERAL REGULATIONS Capacity means a TT&L depositary's ability to accept additional investments in its Treasury Investment Program (TIP) main account balance and/or its Special Direct Investment (SDI) account balance. DUMBER: Capacity is a bank's ability to accept money from the Treasury through TIP or SDI (two of TT&L's programs). Keep in mind, the Treasury only lends because it wants interest. Let's get more specific though.... With respect to a TT&L depositary's TIP main account balance, capacity means the balance limit or current collateral value, whichever is lower, minus the total of: the depositary's current TIP main account balance and any pending investments, plus any pending withdrawals. DUMBER: Capacity is limited by either a predetermined balance limit or the collateral value available to the bank. I can tell you this: the bank's balance limits are not the problem. They are not pushing the limits at all! So the limiting factor has to be their collateral. So the formula is: Bank's Capacity = bank's collateral value (bank's TIP account balance + withdrawals + pending investments) Remember, the bank's TIP account balance is just the sum of its borrowings from the Treasury through the TIP program. And the point of the TIP program is what? Maybe you skipped it earlier, so here it is again: The Fed uses TIP to help keep the Treasury balance at 5 billion. So TIP is used to forecast the balance and then either call money back or give money out to defend the 5 billion target.

So look at page 11. Look at the chart and read the magic words. All together now. "Since 2005, average overall TT&L capacity has declined by 13 percent." By law, a retainer or investor institution (banks!) must pledge collateral against its Main Account balance. So if they don't have collateral, they can't get no TT&L. I'm not talking dirty, I'm just saying: 1. No collateral means no capacity. 2. No capacity means no money from the Fed via the Treasury through the TT&L program. So.... Are banks running out of good collateral? This indicator says: YES!

====BONUS SECTION==== Were you aware? -Most collateral pledged to the TT&L program is priced and marked-to-market on a frequent and regular basis? -Common and Preferred Stock is not acceptable as collateral -Collateralized Bond Obligations (CBOs) are not acceptable. -Collateralized Loan Obligations (CLOs) are not acceptable. -Most Collateralized Mortgage-Backed Securities (CMBS) are not acceptable.** **Real Estate Mortgage Notes (one-to-four Family Mortagages ARE acceptable only if held in a Borrower-in-custody (BIC) arrangement (this means, the notes are retained on the premises of the bank).