Money Flows Part 2
Research for Online Investors

by John Dalt

8/10/10

Today, we complete the reprint of emails your editor exchanged with paid up subscriber D.E. last weekend. These questions and answers should help many understand the current money supply efforts by the Fed and how it is affecting the economy and stock market. This is good information with the Fed meeting and releasing a statement earlier today.

John---  Only the velocity of the money produces inflation.  Additional money sitting on bank balance sheets being used to buy treasuries does not produce inflation.  That is why two Fed governors want to raise the short term rate on loans to banks, to squeeze the interest rate spread, so they will make loans into the economy. The Fed takes back the money and reduces money supply (to control inflation) by not renewing or rolling over the short term loans to the banks.  The money is gone.  Now the banks have loans to commercial enterprises funded with their own capital or depositors, and the cheap Fed money is gone. The bank’s loan policies in the past were not "bad" but were made in a different economic environment.  The mortgage backed securities (MBS) that were tossed around like penny stocks by the big banks never infected community banks. The exception being some smaller banks may have bought some of these high yield, investment grade????, securities for their securities portfolio.  Big Mistake.

D.E.---  You said “The bank’s loan policies in the past were not "bad" but were made in a different economic environment.   Well, I think that a bank that made no money down loan to a credit questionable borrower in a regulatory environment whereby said borrower could just walk away from the mortgage - that's a bad loan in my opinion. Not all cases as extreme as this, granted, but you know that the banks were under pressure to make risky loans for political reasons. So, the banks have chosen to invest the money in Treasuries at ~3% interest instead of loaning it out to individuals and businesses. Do you think that this is because the demand for loans is just not there, or is it because the banks regard making the loans to businesses as too risky given the interest rate difference they could get?

John--- I agree with you on mortgages. I was making a point concerning loans that banks held.  Commercial and consumer, not mortgages that were sold to Fannie Mae, Freddie Mac or Goldman Sachs. The banks no longer have a strong business reason to make commercial and consumer loans since they can make a nice spread buying treasuries.  The economic environment is more difficult for businesses, as the future is uncertain around future government action. Many banks got involved in the mortgage business, but they were only originators.  They wrote the loans for the other entities that bundled them and sold them into the market as MBS. This was a profitable brokerage business for many small banks as they were paid a "loan origination fee", but did not help them investing their capital.

D.E.---  You said “The banks no longer have a strong business reason to make commercial and consumer loans since they can make a nice spread buying treasuries.“ Yes, I can see that, but to "force" the loans, why doesn't the Fed eliminate or reduce that spread? In that event, I don't like it because it would lead to inflation, but I don't see what's holding the Fed back from their perspective (faulty economics). No, they don't want inflation, but maybe they were hoping for recovery and growth anyway without the push from inflation.

John--- Raising the short term rates has the effect of forcing the banks to loan money to customers since they cannot rely on treasuries to make money. This pushes the money into the economy, and off the banks books in safe bond investments. This will lead to inflation as the velocity of money increases, and the Fed will gradually withdraw the Q.E. money. This is accomplished by not renewing or rolling over the short term loans to the banks. This is the way the Fed believes they can control inflation, by expanding or contracting the money supply and increasing or decreasing the velocity of money. This has been the position of some Fed board members, but the Fed has elected to keep short term interest rates low. This has allowed banks to make money, even though loan demand is low. Low treasury interest rates also help the government borrow the massive amount of money needed to fund the deficit.

D.E.--- I have the feeling that the Fed has been trying to play it kind of conservatively after the meltdown was supposedly averted, hoping that the economy would recover faster than it has, especially jobs. But now that the recovery is so slow, jobs are still in the tank, and with the shakeup of the "expert" advisers in the Administration, I sense that changes are coming. We'll see what the Fed says this week.

John---I agree.

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The Fed statement after lunch today repeats the language of maintaining low interest rates for "an extended period."  They tipped their hat to rolling over and reinvesting maturing funds into treasuries.  This isn't new money, but they are not pulling any back either.  The Fed maintained interest rates at 0.00% to 0.25%

Bank stocks jumped on the news they will get to keep borrowing money cheap and buying Treasuries to play the spreads between short term rates from the Fed and longer term treasury rates. Gold and silver jumped, the dollar sagged. The DJI was down 115 points before the Fed's release. The market rallied immediately.

Our take?  The Fed has punted.  They could have raised rates by a quarter percent.  This would have sent the message to banks they needed to loan money into the economy.

The U.S. House of Representatives has voted to throw $26 billion in "walking around" money out before the fall elections.  This money is to help states keep from laying off teachers and policemen.  Both careers were always local jobs and recently union jobs, but now it seems they are becoming a Federal responsibility.

Today's Quote:
Socialism is a philosophy of failure, the creed of ignorance and the gospel of envy, its inherent virtue is the equal sharing of misery.- - Winston Churchill

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future.

Money Flows Part One

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