Are our banks on life-support?

Somebody must have noticed the disappearing reserves at the Fed, because the Federal Reserve Bank felt compelled to post this explanation:

The negative level of nonborrowed reserves is an arithmetic result of the fact that [Term Auction Facility] borrowings are larger than total reserves.

Well, no kidding!

This reads like a high school paper. Two bloated paragraphs to say we borrowed more money than we actually have in the vaults.

But why, how, and what does it mean? This has never happened — repeat, never happened — during the nearly 50 years for which statistics are available.

Now, I admit that I don’t know enough about complex economics to analyze this very deeply. Other (smarter) observers who’ve noticed, like naked capitalism, are not ready to panic:

[T]his unprecedented pattern was clearly the result of the Fed’s implementation of its TAF, the Term Auction Facility, which gives banks funding if they post collateral (and it can be plenty crappy collateral) at better rates than they can get in the interbank market. In other words, banks would be nuts not to use it.

Okay, that makes sense. However, NC goes on to note that a strategist at UBS, one of the banks reeling from the collapse of the subprime mortgage market, thinks that the Fed may in fact be propping up the banking system:

….a savvy bank can put down lesser quality paper that it can’t generally do very much with (and certainly no one else really wants it), raise funds through the TAF, then use those funds to put down as reserves, and then conveniently gets paid a modest rate of interest against those reserves (which acts as a partial offset against the TAF). While there’s a small net cost to the banks, the real loser here is the Fed, what it gets stuck with is an ever growing pile of collateral.

Now consider this – that collateral is actually what’s backing the entire US banking system by way of its conversion to dollars and then the flow of those same dollars back to the Fed….

In other words, if this theory is correct, the dollar is now on a “subprime mortgage” standard!

Nonsense, writes Caroline Baum of Bloomberg! Those of us worrying about this minus sign are — wait for it — “the Black Helicopter/Tin-Foil Hat crowd.”

Banks are required to keep a certain amount of funds in reserve — as vault cash or on deposit at the Fed — to meet unexpected deposit outflows. These are called required reserves (catchy, isn’t it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed’s discount window) or non-borrowed (supplied via the Fed’s daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don’t need to tap the interbank, or fed funds, market.

What’s caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn’t a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Well, the answer seems obvious — until Mike Shedlock asks an obvious question:

If Citigroup could have borrowed reserves from the Fed at 3-4% wouldn’t it had done so instead of raising $7.5 billion from Abu Dhabi at an interest rates of 11%?

Exactly. And then going back for more on even lousier terms.

Here’s another thought: A lot of us Americans — self included — got into trouble by counting the equity in our homes — i.e., borrowed money — as reserves. When the collateral — our mortgages, some of which are now being used by some of the banks at the TAF, if I understand correctly — went *poof*, so did our “reserves”. Where did we get the money to pay when the bills come due?

We didn’t. And where will the banks get the cash to cover their reserves when the value of its paper goes *poof*, as it’s about to do?

Shedlock continues:

Here’s a statement that caught my eye from Baum’s article made by one of my favorite economists, Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

“There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP.”

On this point, I believe Kasriel is correct. However, the Fed has not been concerned about many things that history proves they should have been concerned about: housing, lending standards, derivatives, ARMs, and asset bubbles for starters.

Here’s the deal. Bank reserves are net borrowed. This comes at a time when commercial real estate is about to plunge and bank balance sheets are loaded to the gills with them.

Gee, even with my lowly B.S. in Economics I can figure out what that means: Dozens of bank collapses are on the horizon.

Thankfully, I can call on John C. Dugan, Comptroller of the Currency, for expert testimony to back me up:

Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.

There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures.

Read that again: Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.

That’s a recipe for disaster.

Bottom line: The experts either really don’t know or don’t want to admit in public what’s going on here. Just remember that, whatever it is, it’s something we haven’t seen in more than a generation.

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