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The Banks’ Newest Sweetheart Deal

by Michael S. Rozeff

On Dec. 28, 2009, the Federal Reserve (FED) released its proposal to pay interest to banks on
term deposits. At present, the FED pays interest on bank reserves (both required and excess) at a
rate of 0.25 percent. With the incentive of higher short-term rates to be paid on term deposits,
banks, when this proposal becomes effective, can convert their reserves into term deposits, at
what will be a higher rate of interest. The rates will be determined by an auction procedure with a
maximum allowable rate to be paid. The funds in term deposits will no longer be available as
reserves or to make payments over the life of the deposit. However, they will be usable as
collateral if banks wish to borrow against them at the discount rate (currently 0.50 to 1.00

This proposal has been in the making for awhile. It cropped up earlier in the notion of Federal
Reserve bonds, discussed here a year ago. It is billed as part of the FED’s exit strategy (from its
balance sheet expansion), but it’s really a strategy of controlling that balance sheet, not reducing
it. It’s a strategy of consolidating the FED’s enlarged role. It’s also a strategy of influencing the
perceptions of market participants so that they do not thwart the FED’s actions by driving up
interest rates, fleeing from the dollar, or moving heavily into gold.

When this proposal is implemented, as it will, the FED will use it to sterilize an unknown portion
of excess reserves, now present in the amount of $1.077 trillion. Sterilization means that the term
deposits at the FED no longer can enter into a multiple deposit expansion process in the banking
system. (They will still be the result of a one-for-one deposit expansion.) The amount sterilized
will depend on how large an amount that the FED offers to banks on an auction basis and how
much they buy.

The sterilization can only be achieved using this technique through continuing and repetitive
auctions. Through this method, the FED can control bank reserves without buying and selling
securities. It can buy time to sell off its oversized portfolio of mortgage-backed securities,
although only token sales are likely in an attempt to manage market expectations. It can expand
bank reserves by offering fewer deposits for sale, or it can contract them by offering more.

The reason for this proposal, according to the FED, is that it has supplied “an unprecedented
volume of reserves to the banking system.” The latter is true. The FED enormously inflated the
monetary base, providing the banks with the wherewithal to expand the money supply by an order of
magnitude. The FED’s announcement says “Term deposits could be part of the Federal Reserve’s
tool kit to drain reserves...” This is not entirely accurate. The term deposits will have rather short
maturities of 16 weeks or less. They neutralize reserves temporarily at a price that must be paid on
an ongoing basis. They do not remove them or drain them in a permanent or even semi-permanent
sense. That can only be done if the FED sells securities outright that it now holds as assets.

A number of things are associated with this proposal, of which I will mention five to begin with.
(1) In the past year or so, the FED supplied the U.S. government with vast credit. It included
$300 billion to the U.S. Treasury and another $1.2 trillion for mortgage-related securities of
Fannie Mae and Freddie Mac, now under government control. (2) In the process, it brought
yields down on these securities. This has distorted both capital and credit markets by holding up
asset prices. (3) The FED engaged in fiscal policy by directly exercising a one-sided preference to
support housing markets. (4) Due to the nature of the U.S. monetary system, these FED
purchases of U.S. securities more than doubled the monetary base (currency plus bank reserves.)
Since bank reserves are convertible into currency, the FED vastly inflated the supply of non-
interest bearing Federal Reserve notes or dollars. This has prevented prices of consumer goods
and services from declining. (5) The FED’s purchases helped prevent insolvent banks from

The FED’s excess earnings from the securities it buys, beyond its operational requirements,
ordinarily go to the U.S. Treasury. But if the FED pays 1 percent interest on $1 trillion of term
deposits, the U.S. Treasury receives $10 billion less. In other words, taxpayers pay the banks $10
billion a year not to make loans to the public but instead to buy the FED’s term deposits. This
risk-free investment has a present value to the banks of $1 trillion if continued forever
(discounting the future cash flows at 1 percent and neglecting taxes that the banks pay.) This is a
massive sweetheart deal in which the U.S. government transfers taxpayer wealth to the banks.
This is a sixth outcome of the FED’s actions that is about to occur. It is fitting that the FED
announced this Christmas present on Dec. 28. The taxpayers are being forced to play Santa Claus
to the banks. This is a hidden bailout that has received no publicity.

Long-term yields are now starting to rise. The banks are starting to have a greater incentive to
buy the mortgage-backed securities from the FED or help finance others to buy them. But the
FED will lose money whether they sell them or not, due to the rise in yields. This will lower its
capital. The loss will be felt in the higher risk and lower value of the FED’s notes (the dollar), if
it has not already been felt. This is a seventh effect of the FED’s aid to Fannie and Freddie.

In the past two years, the FED has moved more and more into the fold of the U.S. Treasury or the
government. FED independence has never been all that much present, but what degree there was
has gone down even further by its massive subsidization of home loans and now by sterilizing
bank reserves.

The FED and the government are acting somewhat like the American colonial land bank system
of the 1700s. But today’s monetary system is actually worse than the colonial land banks in
important respects. The colonial land banks were operated by colonial government loan offices
that issued paper currency against “sufficient collateral, normally real estate with a market value
at least twice the size of the loan,” according to historian Edwin J. Perkins in his book (p. 70)
American Public Finance and Financial Services, 1700-1815. This was true of some, not all the
colonies. In any event, today’s ratios of value to the loan are far lower. The colonial system was
decentralized down to the state and local levels. In New England, local town boards made the
loans. In New Jersey and New York, it was county boards. Because of this, the lenders knew the
borrowers. The current system of lender mortgage origination followed by resale to government
agencies has undermined the connection between borrower and lender at the local level. Colonial
legislatures promised to redeem their bills of credit, while FED notes are irredeemable. Colonial
currencies competed with each other; they were not monopoly issues like the FED’s. Loan terms
of maturity were shorter than today’s. The colonial currencies were not usually legal tender. The
other major difference between then and now is that colonial debt was far lower. The FED-
government nexus today is much less constrained in fostering a debt-laden system than were the
colonial legislatures of yesteryear.

In some respects, little has changed in 300 years. The colonial currencies depreciated, just as
FED notes have depreciated.

But one thing that the colonial system could not have had and didn’t have was a sweetheart deal
by which banks received taxpayer funds for not making loans. Legislatures usually went easy on
borrowers who were overdue on payments. The vast majority of borrowers were ordinary
farmers, mechanics, and people who had trades. The taxpayer money that legislatures gave up by
shoddy collection practices largely found its way into the hands of taxpayers acting as borrowers.
It was not siphoned off into the coffers of banks.

The FED can succeed in sterilizing bank reserves. Taxpayers will foot the bill, for if Congress
insisted on receiving all the interest income from the FED’s securities, the FED would be unable
to pay the necessary interest to banks without impairing the dollar. Once the FED gets used to the
new procedures, the door will be open to more quantitative easing, i.e., new credit creation
directed to the U.S. government. The government credit bubble can be blown up further with the
FED’s assistance because the FED will have a tool to neutralize the resulting reserves. The
government, actually taxpayers, will be paying the banks more and more money for doing

With the use of this tool, U.S. government control over the American economy takes a giant step
forward. If a power like this is pushed to the limit, what happens? When the FED sterilizes bank
reserves and directs credit to the government and its favored enterprises, the government can
distribute funds to any projects that it favors. It can bypass banks entirely, or it can see to it that
the FED provides them with enough reserves to lend to areas that it favors. America then moves
further into a government-managed economy. Such an economy has fewer and fewer projects
that create wealth and well-being, and more and more projects that lose money or destroy wealth
and well-being. The economy’s ability to generate returns on invested capital declines, which
spells low returns for a host of securities. Eventually, perhaps years from now, a battle will erupt
within government about paying off banks for doing nothing. The banking lobby will want to
continue the subsidy. Its opponents will want to absorb the banking system entirely.

What will happen to the dollar if the FED’s power to neutralize reserves becomes habitual? The
government will target more and more dollars to unproductive purposes, as it has done with
housing and a few other selected areas like AIG and autos, and as it is doing with energy. The
FED will supply those dollars, and the result will be that the dollar declines in value. For
example, the Obama administration already has removed limits on providing taxpayer funds to
Fannie and Freddie. GMAC has its hand out for more. As the economy becomes more and more
government-managed, the currency becomes less and less suitable for international commercial
transactions as its value is questioned and as the economy becomes less and less important within
the world economy. In the Soviet Union, there was an official currency conversion rate and a
black market rate that more accurately reflected the centralized economic control.

These are economic possibilities, on the horizon but drawing ever closer, that the FED’s recent
actions portend. The U.S. economy is moving into a qualitatively different structure in which
centralized management plays a larger role than ever. A popular or populist-oriented third party
movement among Americans that resists this tendency might conceivably cause one of the major
parties to alter course in order to gain power, in which case the centralizing tendency might be
slowed or aborted. However, the fact of the matter is that America has been proceeding in the
opposite direction for a very long time. Centralization speeded up in the last few years.

For the present, the banks have a sweetheart deal. Their long-run picture within an increasingly
controlled and centralized economy is not so sanguine. Neither is that of the American economy
and the American people.

Michael Rozeff is a retired professor of finance. An archive of his articles appears here. Other of
his articles may be found here. His technical finance papers are available at SSRN.

All of Prof. Rozeff’s essays, including the work above, contain information, data, opinions,
judgments, hypotheses, theories, ideas, and conclusions that are tentative, subject to revision, and
subject to error. They are written and published in order to focus his own thinking, to stimulate
the thinking of others, and as a public service. They are not written as investment advice or as a
reliable basis for making investment decisions. Prof. Rozeff is not in the investment advisory
business in any capacity and provides no investment advice. He has no responsibility for any
investment decisions that readers may base upon his writings or for any losses that may result as
a consequence of reliance upon or interpretation of his writing. As speculating and investing
involve risk of loss,.he advises readers strongly to seek out professional advice from professional
investment advisors and/or to make their own investment decisions after due diligence and
research that comprehend a variety of sources. Prof. Rozeff may have a long or short position in
securities or markets that he mentions.

January 2, 2010