Expert: Gina Boykin - 8/13/2007

Question
Hi Gina, this past week the Fed Reserve  pumped $35B into the banking system because of liquidity issues with subprime loans.  My question is what does the pumping into the system mean? Is it a loan, who gets the infusion?  Can't find the ans. Pls help

bill

Answer
Before I explain, let me start at the basics of banks and the FED.  The FED is made up of the Board of Governors, the FOMC (Federal Open Market Committee), and the Reserve Banks.  The FOMC handles all monetary policy decisions.  The FOMC can use three tools to carry out its monetary policy goals: the discount rate, reserve requirements and open market operations.

The discount rate is the rate charged by the Federal Reserve banks to local banks for overnight loans.  If this rate increases they are "tightening" the money supply.

Reserve requirements - Banks are required to have primary reserves, or a % of total deposits in cash.  The remaining amount can be used to provide loans.  The primary reserves % is determined by the FOMC. If this rate increases, they are "tightening" the money supply.  The opposite will happen if they decrease the reserve %.

Banks also have secondary reserves, which can be loaned to other banks overnight (@ the federal funds rate) if a bank needs cash to meet it's primary reserve requirement.  If banks have a lot of cash, this leads to a decrease in the federal funds rate.  The opposite happens if there is less money to lend.  This is basically the law of supply and demand.

The FED can also use the open market to affect the monetary policy.  The Federal Reserve Bank of New York carries this procedure out, based on the direction of the FOMC (Federal Open Market Committee).  

Here's what happened this week:

The FOMC decides if it wants to ease up, tighten, or maintain the nation's money supply.  Because there are liquidity issues with loans, the money supply is in danger of tightening.  What this means is that banks will have less to loan, which I stated earlier means that the federal funds rate will be driven up.  If banks have to pay more to borrow money, so will you - interest rates will go up. This would be a bad cycle.  Why? Because the reason that the subprime loans are going bad is (1) interest rates have risen on all of these interest-only, ARMs, and option ARMs loans (2) housing prices have declined.  People tapped their equity when housing prices increased and now they may owe more than their house is worth.  

If rates go higher and the housing market continues, more loans will default.

The other issue at play is that large instituions are holding bonds full of subprime loans.  As the loans default, these bonds decline in value.  These companies will have huge losses and their stock prices will plummett.

So with all of this going on, the FOMC "eased up" on the money supply.  The Fed can buy or sell treasuries on the open market.  When it wants to increase reserves (amount of money banks have to lend), it buys securities.  The broker/dealer then gets cash, which then flows through the banking system.  When it wants to decrease reserves, it sells securities.

The FED usually purchases government bonds (treasuries).  Because the issue is with subprime loans, though, the FED purchased these bonds - which no one else was buying.  These bonds are estimated to be worth much less than their original price, and could go lower if more loans default.

The FED did NOT decrease interest rates to solve the problem because this would cause inflation.

Hope this helps!

-Gina