Greetings!
Have you been asking yourself the question, "what are banks doing to make money after the sub-prime mortgage meltdown?" If you were, you might be surprised to find out the answer.
For the last 8-10 years I have gone out of my way to tell clients and others to stay away from the large institutional banks like Bank of America, Wells Fargo, and others, with extra special emphasis to stay away from Citibank. The reason? Banks are not our friends. In fact they have not been our friends for quite some time now. Banks were originally formed to perform two important functions; 1) loan money to those who needed it to build their business (like farmers who needed money to produce crops and then pay off their loan once they sold the crops), and 2) hold your hard earned money on deposit and keep it safe while giving you a small rate of return in the form of interest.
Last time I looked no money is being loaned unless you could prove to the bank that you had more than you needed. The rate of return being offered today is miniscule. And as for keeping your money safe, well there are no bank robbers these days but there sure are a lot of bank failures.
I grew up in the sixties in San Francisco where my father had a small business and banked at the B of A branch in North Beach. Take a moment if you were around in the sixties and try to remember how banks operated back then. If you recall, Banks used to be managed by someone called a "Branch Manager" who had their office in the back but within view so that the Manager could see what was going on, and more importantly, who was entering the branch.
I remember going with my father on numerous occasions and the branch manger would see my dad entering and come out to greet him, and after a few initial niceties he would ask, "all right Mike, how much money do you need this time?" We would be ushered into his office where my father and he would carry on like old friends and eventually my father would get the $10,000 loan or whatever he needed. The branch manager knew my father was good for it and had loaned my father money many times before. My father knew he needed the branch manager to run his business and to help my father buy a house for his family, and so, he always paid his loans and kept a clean record. Days gone by!
Today, banks like Bank of America are making money by borrowing from the Fed at low rates, and lending to each other at higher rates. They are also taking this money from the Fed and in many instances giving it to the Treasury Dept as they buy government bonds with high yields. In other words, today the Federal government and the Federal Reserve are the primary source of income for large institutional banks.
The post sub-prime strategy of the Mr. Bernanke was to flood the system with cash, and with that the Fed Funds effective rate has now dipped below 16 bp. (i.e. 1.0 per cent equals 100 bp). The Fed makes funds available for borrowing by Banks like B of A through what is called "The Discount Window." This window helps to relieve liquidity strains for individual depository institutions and for the banking system as a whole by providing a source of funding in time of need. This is most definitely a time of need for Banks.
In December of 2007, the Federal Reserve introduced the Term Auction Facility (TAF), which provides credit to depository institutions through an auction mechanism. Before the current financial crisis, primary credit was available on a very short-term basis, typically overnight, at a rate of 100 basis points (1.0 %) above the Federal Open Market Committee's (FOMC) target rate for federal funds. In addition to that the Fed also implemented numerous changes to the primary credit program.
For example, on August 17, 2007, in an effort to promote an orderly market, the Federal Reserve lowered the spread between the primary credit rate and the target federal funds rate to 50 basis points and instituted increased lending terms allowing banks to pay off the money for terms as long as 30 days, a considerable increase from overnight lending.
On March 16, 2008, to further enhance monetary liquidity, the Federal Reserve once again lowered the spread of the primary credit rate over the target federal funds rate to 25 basis points ( ¼ of 1%) and increased the maximum maturity on credit loans to 90 days. More detailed information on this topic is available on the Fed's Discount Window website at http://www.frbdiscountwindow.org/
The TAF program currently makes available to banks who qualify term funds of up to $125 billion per auction, and for a term of 28-days or 84-days maturity. That is a nice source of available cash from which institutional banks have seized the opportunity given to them. What banks are doing is this; borrowing the money with extended maturities at 25-50 bp, placing those funds in the market via loans to other banks who do not qualify to borrow from the Fed and charging a slight up charge, and using some of the money to buy Treasuries at very attractive yields in excess of what it costs them to borrow. Furthermore, any money they do need for operations they borrow on the overnight window.
The risk to the bank is that the Fed may suddenly raises rates, making overnight financing more expensive than term. Yet, given the commitment of the Federal Reserve to help re-work their balance sheets, there is little likelihood this risk will ever surface. Therefore, with the overnight rate staying under 25 bp, the 1-3 months term rate at 50 bp, these transactions generate 25 bp in profit. The Fed wants it that way to improve interbank lending, reduce reliance on TAF, and boost bank profitability.
So the next time you go to the bank to borrow and they turn you down, understand that they are doing quite well without your loan payments. In fact, they are doing quite well and you and I are paying for it with federal funds, yet not receiving one penny of benefit in the way of higher interest rates on our deposits, or more importantly, in the way of loans to buy extremely affordable real estate.
Shall we all now hold hands and sing Kum Ba Yah?
Have a great weekend! 
