Are Major Changes Coming to US Banking?

On today’s show we are looking at what the Fed could do that would cause a major increase in demand for US Treasuries. If the demand for Treasuries were to increase, the prices would rise and the market rate for those bonds would fall. 

The US Treasury would no longer be dependent on the interest rate guidance coming from the Federal Reserve. That could save hundreds of billions per year in interest costs for the US government.

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Episode Transcript

(00:02):
Welcome to the Real Estate Espresso podcast, your morning
shot of what's new in the world of real estate investing.
I'm your host, Victor Minash. We've seen a general trend where
the yield on U.S. Treasuries has been rising over
the last six months, which has also increased borrowing costs
for real estate investors. Most real estate loans are
indexed to the yield on the 10 year treasury.
A worry over increasing U.S. debt has also fueled concerns

(00:23):
about the sustainability of U.S.government debt and the eventual
trap that's inherent with deficit spending.
Foreign governments, specifically China, Japan, and
Saudi Arabia, have all been reducing their holdings of U.S.
Treasuries. While today's show we're looking
at what the Fed could do that would cause a major increase in
demand for U.S. Treasuries.
And if demand for U.S. Treasuries were to increase,

(00:44):
prices would rise and the marketrate for those bonds would fall.
The yield would fall. That would be equivalent to a
reduction in interest rates without the Fed actually
declaring a reduction in interest rates.
If that happens, U.S. Treasury would no longer be
dependent on the interest rate guidance coming from the Fed.
That could save hundreds of billions per year in interest
costs for the US government. In order to understand this, we

(01:06):
need to go back to 2008. On October 3rd, 2008, the
Emergency Economic StabilizationAct of 2008 accelerated the
effective date for the Federal Reserve to begin paying interest
on both required and excess reserves.
This is what's called IORB. It was originally authorized by
the Financial Services Regulatory Relief Act of 2006,

(01:28):
but it was pushed forward due tothe crisis and the Fed began
paying interest on reserves on October 6th of 2008.
The mechanism specifically was to combat the severe economic
downturn and to inject liquidityinto the financial system.
It was really designed to protect the banks and the Fed
initiated large scale asset purchases.
It was called quantitative easing.

(01:49):
That was a new term at that time.
This involved buying massive amounts of U.S.
Treasury securities, mortgage-backed securities from
commercial banks and other financial institutions.
The effect on reserves was that when the Fed buys assets from
the banks, it pays for them by crediting the bank's reserve
accounts with the Federal Reserve.
That increased the total amount of reserves in the banking
system, and since banks were notlending extensively due to the

(02:12):
crisis, a significant proportionof these newly created reserves
ended up as excess reserves, that is, excess over and above
the statutory minimums. Quantitative easing essentially
swapped less liquid assets on bank balance sheets for highly
liquid reserves. Prior to 2008, the banks had
very little incentive to hold excess reserves because they
earn no interest on that money. Any excess cash would typically

(02:34):
be lent out in the federal fundsmarket.
Other banks that needed to meet those reserve requirements or
perhaps if they needed additional liquidity by paying
interest on reserves, money thatthe Fed actually had printed.
the Fed provided banks with a risk free return on their
holdings at the central bank. That fundamentally changed the
business model for the entire banking system.

(02:55):
In the highly uncertain post crisis environment, with weak
demand for loans and heightened risk aversion, banks found it
attractive to simply hold the excess reserves at the Fed to
earn interest rather than lending out those funds in the
broader economy where the returns were uncertain and maybe
the risks might have been higher, That provided a floor
for the banks at the Fed funds rate.
Banks wouldn't lend at a rate below what they could earn risk

(03:17):
free at the Fed. So if the Fed stopped paying
interest on those excess reserves, and by the way, if the
Fed printed that money anyway for the benefit of the banks,
then the banks would no longer need to keep those excess
reserves at the Fed and the Fed could stop paying interest on
that excess cash. See by the fall 2009, the year
after this was implemented, the Fed was paying interest on $1

(03:38):
trillion of newly minted cash tothe member banks, those banks
that are members of the Federal Reserve System.
By July of 2013 that number had grown to $2 trillion and then it
peaked at $4.2 trillion in the fall of 2021 during the height
of the pandemic. Today the Fed is paying interest
to the member banks on 3.3 trillion.

(03:58):
So understand the part of 2008 this was an insignificant factor
in the Feds liabilities and today the Fed is paying interest
at what amounts to 4 1/4% to itsmember banks on 3.3 trillion of
risk free money that the banks have loaned back to the Fed.
So where is this cash coming from to fund that $140 billion
in interest payments each year? Well you guessed it, it's coming

(04:20):
very likely from the taxpayer. So if the Fed eliminated the
practice of paying interest on these amounts, what would that
do? What if the banks needed to find
another low risk vehicle to purchase?
What if they bought treasuries and T-bills of differing
durations? If the banks need access to
liquidity, they can use those instruments as collateral and

(04:40):
put those risk free instruments on deposit at the Fed in
exchange for cash. That would put downward pressure
on the rate the US government would have to pay on its debt.
After all, there would now be demand for $3.3 trillion in
additional buyers for U.S. debt.For example, if the interest
rate on the two year Treasury today is trading at 3.74%,

(05:00):
nearly half a percent less than the Fed funds rate, I would say
the federal government a bunch of money.
If the bank swallowed up another3 trillion in U.S. government
bonds, the rate that the Treasury pays on its debt was
likely fall even further. This is a way of reducing the
government's cost of borrowing without the Fed actually having
to publicly lower interest rates.
It would reduce the relevance ofthe Fed Board of Governors when

(05:22):
it comes to setting interest rate policy.
Now, this is not something that's being widely reported in
the news, but I believe it's worth tracking.
If this change happens as expected, it's a monumental
shift of $3.3 trillion and how the US funds the excess reserves
at its banking sector. As you think about that, have an
awesome rest of your day. Go make some great things

(05:43):
happen. We'll talk to you again
tomorrow.