Plays a Role in Harming Banks and the Overall Financial System:
A small town community bank perspective.
By Michael J. Dunton
Creation of Excess Reserves Earning 0.25%
Let me explain to the average reader what excess reserves mean in a context of a small community bank. Each day a young lady from my staff would come into my office and show me where we were at, in cash (paper and electronic), from the day’s course of business. I always had to know what time it was in the morning so as to be ready for her visit between 11:30 and Noon—I sometimes could be in a meeting in the building, or could be somewhere about town. If we needed cash, I would call up the Federal Home Loan Bank that we belonged to and borrow overnight funds—or I could borrow for 30, 60, 90, 12, 180, or 360 days if the rate was too good to pass up. We could even borrow on a term facility for up to 30 years, but going out that long on the yield curve, whether borrow or lending, is a bit dramatic for me. The same goes if we had excess cash: I could lend it out overnight, or buy a CD of varying maturities and rates.
That was then.
Fast forward to now and we get the situation where we haven’t had to borrow for daily liquidity for so long that I have forgotten the Federal Home Loan Bank’s phone number and our bank’s account number (don’t worry, I have it written down). We are swimming in excess cash. We see this as a result of several events: first, mortgage-backed securities we hold have been paying off at a faster speed due to the Federal Reserve’s purchase of MBS in the market; second, our loan demand is down—our loan balances are about 5% lower than normal; third, other bonds' yields are being dragged down and issuers are calling the higher yielding securities and reissuing new bonds at lower yields; lastly, our customers are holding higher cash balances. I now needn’t worry if I have to borrow for my daily liquidity on any given day for the foreseeable future—I just need to worry how to stay in business with $15 million stuck earning 0.25% and flat to decreasing loan demand for the next year.
Let’s explore why the Fed has been affecting excess reserves by way of buying up mortgage-backed securities. The Fed is trying to stimulate the economy, help homeowners, and buoy the banks by re-inflating the housing asset bubble. Most mortgages are rolled up into securities (MBS) and sold to investors. We’ve written, through November, $126 million in mortgages versus $58 million last year. We’ve only kept on our books about $28 million in mortgages. Most of our mortgages are sold to Fannie, who then rolls them into large pools of MBS. Regular banks (the big boys), in the past, have done the same thing as Fannie and Freddie and rolled their mortgages into private-label MBS. As I will discuss later, Fannie and Freddie pretty much control the mortgage landscape right now and other players are living off the crumbs.
Depressed Yields and More Risk for Banks
Most MBS are good, but enough of the bad ones went south to affect the entire economy and paralyze the banking system. The Federal Reserve stepped in and bought up enough MBS so as to push mortgage rates down to bring buyers back into the market and prop up housing values. No one outside the Fed is certain what specific MBS were bought and from whom, but it was enough to pretty much control the pricing of all new mortgages. New mortgages were written up as refis and for new purchases. Now when those old loans were paid off at the new closing, the MBS that were connected to those old loans were quickly paid down, if not paid off entirely. That means those older, higher-yielding MBS that banks and other investors were holding gradually disappeared during this time—those MBS were paying a lot higher yield than the new MBS that took their place. Banks investments in MBS now earn less and if we want to replace the yield, on a one to one basis, we have to go out longer on the yield curve and accept more risk.
Let me now try to further explain why the Fed buying up these mortgage-backed securities is harmful to the economy and to banks in particular. When the Fed buys a bunch of MBS, it is overpaying for them—its like a rich guy early in an auction putting a ridiculously high bid on an valuable item that pretty much ends the bidding. This makes the yield on the MBS go down—it forces the mortgage market to offer 30 year mortgages between 4.5 to 5%. Now, no one in the mortgage market likes depressed prices like that for a 30 year income stream, but Fannie and Freddie were there to catch all that action. Don’t get me wrong, we made money doing the dirty work for Fannie and Freddie by originating and servicing the loan, but the risk is all on Fannie and Freddie right now. For the most part, they are the market for the foreseeable future. There are other institutions out there doing the same thing, but the real action is all Fannie and Freddie. Now Fannie and Freddie can push off any screwball regulation and fees on us with impunity. Each new rule and regulation costs a bank to implement through training and changes in systems. So now we’re getting increasingly pinched on the origination side of our business by Fannie and Freddie, which was made possible by the Fed’s involvement in buying up MBS.
Distorted Prices
Finally, the Fed’s foray into the mortgage market, by buying up MBS, has distorted true market prices for mortgage products, both in terms of revenue and costs. As it stands right now, the mortgage market is entirely dependent upon the federal government (the Fed, Fannie/Freddie, and the rest of the DC klunks). We essentially have people running the market, those pulling the strings from above, who derive the livelihood not from their financial performance, but from their position in government. Because banks, especially community banks, derive a large source of their income through mortgage activities, they will be forced to take what the government determines is right. There’s simply no viable alternative to the federal government’s heavy handed tactics in the mortgage market. The average homeowner may think he is getting an absolute steal by getting a sub 5% 30-year mortgage, but as a taxpayer he will receive a bargain he had not planned for. With virtually no private capital alternative to challenge Fannie and Freddie, the distortion will continue and true market prices will be an afterthought.
Summary
The Fed’s actions to help the economy by helping homeowners and banks through purchases of mortgage-backed securities is riddled with hidden costs and unintended consequences. Although mortgages have become cheap and commoditized, banks are earning less from their investments in MBS and direct holding of mortgages. Excessive purchases of MBS, by the Fed, have increased banks' excess reserves while decreasing mortgage loan pricing. These extra reserves now sit at the Fed earning a paltry 0.25%. Furthermore, the mortgage market is almost entirely dependent on the federal government and this has created distortions in price and its correspondent risks. Finally, if the Fed and the rest of the Washington apparatchik decided to get out of the mortgage business, or play a diminished role, then it would do so with the risk of the housing bubble deflating, due to greatly increased mortgage costs to consumers and further weakening banks by collateral values plummeting.
Michael J. Dunton is a SVP at a community bank in Alaska.
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