I can't say I have an intimate idea how banking works, but I believe I do have a general idea. The link above is to commentary by John Hussman, whom I find to possess some of the best publicly available knowledge in finance. After not reading his site for some time, I visited it today. This is his most recent article. It is worth a read to digest how Fed policy is perceived to work. I will try to window dress how I perceive banking to work, so one might get an idea what the Fed can do for banking and what it can't do.
What the Fed can't do is make bad loans good. I am bearish because I don't believe the world can solve its debt problems without systematic pain of massive defaults. Otherwise, the age of free men will come to an end as we have governmentally enforced peonage to a small group of bankers. It appears that bankers are only responsible for making bonuses and not for making good loans any more. Bad loans are the borrowers fault, when in fact, bankers and other financial organizations have succeeded inflating and loading the world down with so much debt that a large percentage of it merely rots on the vine. This would be true whether we had sub prime mortgages or not, as the level of debt at some point becomes much more important than the quality of debt. In fact, the sub prime lending may have prevented the current process from starting earlier, like at the end of the dotcom boom.
In any case, what a credit crunch involves is the inability of one group of financial entities to attract funds from another group or the public at large to satisfy their liabilities. Banking was supposed to be structured on the basis of reserves held in cash and treasury securities. These items could generate rapid liquidity by being presented as payment or redeemed for funds at the Fed. Thus a bank that needed to raise funds would have a very liquid asset in the form of a bond or t-bill to go to market and raise cash.
What occurred in the bubble was the fact that one bank was lending the other bank their liabilities. When banks interact, it is generally through their customers. Thus if bank A creates $100 billion in loans and only attracts back $80 billion in deposits, it has to cover the other $20 billion somewhere. Should the extra $20 billion end up in Bank B, B generally makes A a $20 billion loan overnight or for a period of time. The $20 billion in B is on its balance sheet as an asset, but it is really a liability to a customer who received the money from the borrower linked to Bank A. Thus, A is now liable to B who is liable to its customer who received the funds from a customer that is liable to A. The whole circle is a series of liabilities, none of which are really assets The circle has to be closed or the domino's fall.
In the crunch, the banks were insolvent. They are always insolvent, but they can present solvency as long as the circle works. When massive amounts of assets of Bank A suddenly turned sour and lost their marketability, Bank B began to doubt the immediate solvency of A and took its money back or asked for higher rates. A couldn't sell its mortgage or whatever it had as collateral for the loan and thus was in the midst of a credit crunch. If A possessed a pile of treasuries in the amount of its liabilities, it could have sold them and solved the problem But, A was actually operating with near or below zero reserves, its entire basis of existence borrowed from the market. It was no longer a bank, but a finance company.
The US operated post world war II for about 20 years before there was a financial accident. The war flooded the system with treasuries and gave the banking and private sector massive amounts of redeemable paper. The treasury holdings of the banking system began to run short in the mid 1960's and was pretty much all used up by the mid 1970's and bank had to invent ways to pretend they had reserves. If one examines the amount of currency of the US that has been printed over the years, they have to make the educated assumption that the money left the banking system long ago. No bank would sit on that much non-interest bearing cash. Thus the reserves stated on the balance sheet were gone and replaced by a customer liability that was once represented by the cash. Thus the structure of reserves was merely banking IOU's passed between banks and bank customers. The system of liquidity was replaced by a structure of derivative swaps that I really can't tell you how they work other than to say they are swaps of different interest rates and calls and puts on treasury securities.
The too big to fail banks all took advantage of this financial innovation and pushed their balance sheets to the limits, becoming liable for very sizable amounts of overnight funds. This system has very little implied guarantees, the guarantees being the government, the Fed and the FDIC would take actions to prevent the system from failing. This system operates, not only in the US, but around the world. The dollar being the international mode of exchange, banks in every developed country are involved in the interest rate swaps, overnight loans, etc.
Getting back to the Fed and QEI, QEII, TARP and all the other alphabet solutions, we arrive at the junction of what this article describes. The purpose of all of these programs was to allow the banks to cash their checks. Nothing else. For all practical purposes, the cash in the form of Federal Reserve notes had left the banking system, along with the supply of treasuries, years ago. As I stated, banks were lending liabilities to each other or should I say lending what they were liable in exchange for a liability of the other bank. The circle had to be completed. Once the insolvent borrowers broke the circle down, the offending banks with the offending customers broke the circle, as for the circle to be complete, all liabilities in the circle have to be good. Thus, when the call went out, the supply of treasuries for liquidity were also insufficient to supply the demand implied by the chain of derivatives. The financial engineering couldn't stand the test of time. Minsky brings a lot of this to light in his book Stabilizing an Unstable Economy (I could have misquoted the exact title), that financial innovation leads to credit expansion which leads to instability.
In these alphabet soup solutions, the Fed used what might have been doubtful assets to create money for banks to pass around between themselves. I propose that very little of what is called reserves is to be used for customers, but instead for cashing liabilities between banks. This money is mostly used to limit what banks can do in excess and thus once out of real reserves, the banks balance sheet has to be good or the system collapses. The receiving bank lends back the reserves in the Fed funds market, thus the lending bank makes loans indirectly for the receiving banks.
This is a rabbit out of the hat trick the Fed has pulled off. For one, the Fed couldn't just go into the market and buy existing treasuries, thus taking them off the market, because the derivatives market presented such an implied obligation to deliver that they would have dislocated that market as well. Thus, they had to wait for the government to produce the treasuries. I am not forgiving the prolific spending by our government, except to say that the credit had to come from somewhere. Upon cashing these treasuries, the Fed created the implied cash for the banking system to buy the treasuries back from the Fed. Just as world war II presented the same opportunity, the recession did the same.
If you read the article, it implies to get to a 2.5% interest rate, the Fed is going to have to sell about $1.25 trillion in treasury securities. The money is now in the banking system. The great magic of treasuries, especially t-bills, is they equate to cash and to reserves. They give the banking system the fodder to cash should they need cash for their liabilities. So, it appears for the time being that half the equation has been solved system wide.
But, this does not address the other side of the problem. The other side of the problem is that who holds these reserves and who needs them are two different animals. Reserves only mean something if the conditions exist for the banks to extend credit. I am going to propose that the banks that have the worst financial position are not going to fall over themselves to make further loans, because they are not going to expose themselves to running out of cash again.
I believe a bank is like a guy with a pocket full of charged up credit cards. As long as his checks cash, he is solvent. He may even be able to keep his credit pristine, save for being viewed as over-indebted. If he has a house, he might even be able to solve is credit card problem with an equity loan, thus putting his payments on a lower interest rate and a longer payment schedule. But, he might have a fancy car, a fancy house and be broke all the same. Especially if something happens to the market price of that house and should he find himself living beyond his means again on credit. As long as the checks cash, he will be perceived as having a net worth.
A bank that has made a lot of loans is incurring liabilities as they are making loans. If their liabilities are leaving the bank faster than other banks liabilities are coming into the bank, borrowing the liabilities of other banks through their customer base or through the bank has to go on or they have to sell some of their own exposure into the market. One of the things that hit the big banks was having to take their seemingly limited exposure represented by the SIV's they agreed to fund onto their balance sheets. I don't know a lot about these instruments save to say that they were likely pass throughs that involved assets to be put into CDO's and ABS's where the market flat dried up. The asset based commercial paper market imploded and the only way to fund this stuff was through the balance sheet of the bank. Of course, the money had to be paid to the money market fund that was redeeming and not rolling the paper and the funding requirement of the bank itself went off the cliff. There was no money to write the check, hot or not.
Hussman implies that the US made the same mistake as Japan, not solving the solvency problem. I tend to believe the solvency problem lies with the banks customers and the expansion of debt on the public side of the equation isn't going to solve the private side of the equation. Instead we are going to find ourselves in a long term liquidation process that will slow the economy and make debt increasingly difficult to pay and credit less and less attractive to the private sector. Banks are going to engage in speculation in assets and find themselves permanently cornered as the Japanese banks found themselves in their own stock market. I propose the interest might be short dollars and to unwind that position is going to take years of deflationary symptoms. This is what the system of liabilities are, a series of dollar short, borrow to buy, lend to earn interest, etc. The very act of having to cover the short prevents the price of the asset or whatever one calls a dollar from going to zero. Once the treasuries are put in the hands of the banks, the requirement to produce cash for them will be absolute.
So what is going to solve the problem? I don't see any short term solution to the debt problem other than a debt for equity swap, in the sense that the losses are socialized, first by the wiping out of equity of the owners of the various financial institutions or the dilution of them with the depositors, bond holders and such taking additional equity positions. The government might decree that Bank A has $1 trillion deposit and bond liabilities and $900 billion in good assets, thus is $100 billion insolvent. Next, they might decree that the deposit liabilities are reduced by 50%, that the shareholders in Bank A are declared wiped out and the depositors and bond holders now own the bank on a pro-rata basis. The market would solve the rest, as those that wanted to withdraw their money from the bank would merely sell their newly issued stock and the bank itself would now have $400 billion in capital. There really isn't any other way out of this mess that would solve the problem short term. To expedite matters, the existing shareholders could be placated with a 5% ownership share in the new entity.
I am really curricula to see how this works out. I doubt the politics of the situation are going to allow for any kind of real solution other than the continued perpetuation of zombie banks. The bet here is that the banks can earn themselves to solvency before the economy collapses under the weight of massive debt or the government goes broke. I am betting against it because the system itself is broke on a current basis and the other parts of the system, banks and government, can only draw their solvency out of a solvent system in general. This is not merely a condition of the US, but the world. In fact, the insolvency of the rest of the world has been covered up for years by the increasing ability of the US system to produce credit and remain solvent on a current basis. Thus, the Fed has succeeded in one matter, allowing bankers to cash bad checks for themselves and others.