QE3, Excess Reserves, Mortgage Rates, Bottlenecks, & Risk Management

Okay, so we know that at the Federal Reserve, funds move back and forth between excess-reserve and required-reserve accounts. We also know why. Commercial banks lend to each other but also to non-bank firms and to households. Commercial banks are required to have reserves at 10% of total loans. Reserves at the Fed above that 10% rate are moved to, and held in, an excess-reserves account. (See: Federal Reserve Bank of New York, Staff Reports, "Why Are Banks Holding So Many Excess Reserves?" by Todd Keister and James McAndrews. Staff Report no. 380, July 2009.)

QE3, Excess Reserves, Mortgage Rates, Bottlenecks, & Risk Management

Photo by Sébastien Bertrand

Is QE3 impacting the economy? All other things being equal, will excess reserves fall due to bank lending?

Mortgage rates have already hit new record lows as a result of QE3.

However, banks have a backlog of mortgage applications and can process them only so quickly. Wells Fargo recently added 2,000 employees.

So, as we've stated before, hiring and training mortgage-loan originators (to do proper due-diligence at restored higher standards) are key things: "Loan-Origination Training, Jobs Key to QE3 Success."

If the lenders properly hire and train enough people in a timely fashion and if the Fed moves to reduce the interest it pays banks on excess reserves, then the housing industry should definitely pick up.

Barring some setback (not to be confused with unintended consequences), unemployment will drop.

The Federal Reserve’s purchases of Treasuries and mortgage-backed securities will sum to $800 billion by the end of the year. ...

“These financial market effects should eventually be passed through to more than a 0.6% boost to the level of gross domestic product over the next two years, enough to add about 500,000 jobs and reduce the unemployment rate by 0.3% points,” Deutsche Bank said....

(Source: "QE3 to elevate stock market, home prices: Deutsche Bank")

Slowly, the economy will continue to improve and people will become closer and closer to being able to afford down payments again, etc.

An aspect here that cannot be overstated in terms of overall importance to stability, though, is that lending standards must not be allowed to disintegrate whereby a huge housing bubble would be re-created inevitably leading again to a housing crash. Rating agencies that rate mortgage-backed securities must not be allowed to fudge numbers and fail to do their own due-diligence. As much as some on Wall Street and elsewhere will complain about the burdens of regulations, the Fed and others responsible for regulating and the Congress and White House responsible for the laws over the Fed and those other regulators and rating agencies and banks, etc., must not be allowed to succumb to the under- and incorrect-regulation mistakes that led up to the crash of 2008.

If regulations are to be altered or reduced or increased, let the process be done with long-term vision and not under the misapprehension that banks and others have learned their lesson and will never repeat the errors so, therefore, they can be allowed to function in a nearly completely unbridled manner, as was the case before the onset of the Great Recession.

Greed got the better of them, and the rest of America and even the whole world is going to be paying for it for some time to come. Let's be sure not to drag the global economy through that again.

As for excess reserves going down, there are many ways the Fed can accomplish that; but for our purposes here, it is important for people to come to understand the fundamental money mechanics of base money in the form of reserves. Setting aside vault and ATM cash held by banks outside the Fed's reserve accounts, there are two places for the reserves of a bank to be within the Fed: A master account or required-reserves account on one hand or an excess-reserves account on the other. When a bank creates credit and extends it to a bank customer in the form of a loan, the Fed requires that bank to have on deposit at the Fed 10% of the loan amount. Now, the loan can be made before the 10% is on deposit, but the Fed has an established settlement system and accounting system and requirements such that the lending bank must have the 10% on deposit within a required time frame. It can borrow from another bank to do that, which is called interbank lending -- very common. Banks lend their excess reserves to each other on a regular basis.

So, a bank with 10% of its reserves in the required account and the other 90% in the excess account, can lend out bank-created credit to customers (firms and households) and continue to do so until all of that 90% has moved over into the required account and before that bank needs to borrow from another bank or the Fed itself to make too many more loans.

For those who are interested, this is a combination of the Money Multiplier and Modern Money Theory (MMT) rolled into one to an extent.

What would happen were the Fed to apply negative interest to excess reserves rather than paying banks interest? Well, some people, such as Peter Stella ("director of Stellar Consulting, an organisation that provides macroeconomic policy advice and research to central banks, governments, and private clients. ...formerly the head of the Central Banking and Monetary and Foreign Exchange Operations Divisions at the International Monetary Fund") either missed the part about how bank loans to firms and households moves reserves from any excess to required once the existing required reserves are no longer sufficient to meet the 10% ratio or I'm missing the point of what Peter Stella told Izabella Kaminska of FT Alphaville.

My understanding is that were the Fed to charge a negative rate, banks would want to cause the excess reserves to move into the required account and do so by lending more to firms and households. They would do that to avoid paying the Fed. Of course not only has the Fed had to ease into stimulation because the Fed underestimated, at best, the severity of the nature of the recession, it has to take care not to overheat the economy via stimulating lax lending-standards caused because banks are placed under too much negative-interest pressure too quickly and, thereby, spurred to lend to those who are not credit worthy.

Anyway, we've seen that QE3 has already caused mortgage rates to hit new lows. This will cause more potential and existing buyers to want to buy while rates are low. Housing prices will rise. Development and construction will rise to meet demand to get part of the profits.

The fear is over-inflation, but the Fed had been playing it too safely, so to speak. It will now, with QE3, push constantly while monitoring constantly ready to decelerate and slowly brake and then let up on the brake and start giving it more gas all with the view of coming closer to stability rather than the huge herky-jerky moves of the Great Depression and now Great Recession, which would have been worse than the Great Depression had the Fed not done what it did (not that Congress and the White House couldn't have done a much better job at altering the regulatory regime and authority of the Fed).

What's all of this mean for real-estate investors? Be careful, do your homework, but unless the entire US economy is going completely under and barring some cataclysm, the right properties will be great investments in our view.