The Feds Reaction To The Coronavirus, Explained
In the past few days there have been some dramatic headlines about The Federal Reserve “spending” billions of dollars on saving the financial market, and like most things when it comes to the financial system it doesn’t make any sense to a normal person.
So let me try to break down for you what is happening-
As the coronavirus pandemic has continued to grow worse, financial institutions and banks in particular have been running into a problem, they’re low on cash.
This might seem counterintuitive, we put our money into banks, how could they be running out of it?
You have to remember that, when you put your money in a bank, it doesn’t actually sit in a giant vault. The banks lend your money out in the form of a loan or a mortgage, and put even more money into buying bonds and other investments.
But banks still need access to short term cash so you and the rest of their customers can withdraw money or take out loans. And to get short term cash, banks and other financial institutions turn to something called the Repurchase Market, or the repo market for short.
The repo market allows institutions to make agreements where they exchange an asset for cash, and then agree to buy back, or “repurchase” the asset they traded within a short period of time. The cash exchanged for the asset is generally less than the value of the asset, and the repurchase price will have a small interest rate.
Think of it this way,
Timmy really wants to buy the new Animal Crossing game because everyone at school is playing it, but Timmy doesn’t get his allowance until the end of the month and he really needs $60 in cash now to buy the game.
Jimmy goes to his friend, Max, and offers him a trade. If Max loans Jimmy $60, Jimmy will give Max a signed sports jersey that is probably worth around $100. They then agree that at the end of the month when Jimmy gets his allowance, he will pay Max $70 to repay the loan and get his jersey back. If Jimmy doesn’t pay, Max gets to keep the Jersey.
Now we all know in reality teenagers are cruel and Max would definitely keep the Jersey on the basis it’s worth more than $70. But that doesn’t happen in real life, aside from the fact it would be criminal, the repo market is a huge pillar in the stability of our financial system. And unfortunately as we saw in 2008, if the repo market starts to dry up then banks run the risk of running out of cash. Which is what we’re experiencing right now.
The other important consideration with the repo market is how it impacts treasury bonds. When banks issue a loan, whether it be for a home or a business, they charge an interest rate. For example, if you got a loan for $10,000, and it had an interest rate of 10%, you would owe the lender $11,000 ($10,000 + (10,000 * 0.1)) (and obviously this is a simple example, some interest rates are annual, etc).
These interest rates might seem arbitrary, but the basis of interest rates can be traced back to the interest rate of the most stable bond in the global economy, treasury bonds, which are issued by the bank that sits above all other private banking institutions, The Federal Reserve, or “The Fed” (this is not the most technical explanation one could offer, but it's not worth getting into more detail here).
Treasury bonds are held for long periods of time and only accrue small amounts of interest, but they are one of the safest investments you can make because you’re betting the American economy isn’t going to crash in an unrecoverable way. Banks keep large sums of their money in the form of these treasury bonds.
When banks go to the repo market, they’re often looking to exchange these treasury bonds for short term cash. And in normal times, it’s a pretty simple trade for both parties to agree to. But the coronavirus is causing a ripple effect that is making these bonds and other securities hard to exchange on the repo market.
In particular, the issue seems to be that the market is having a hard time agreeing how much various bonds are worth, creating price instability. This coupled with the fact all of the players on the market are low on cash looking to sell their assets, and not buy debt, is starting to brew a crisis. And it’s important to note, because treasury bonds set the basis for all other loans, price instability here could cause a house of cards to fall down.
So this begs the question, how do we avert a financial crisis?
Just over ten days ago, the Fed announced it was making up to $1.5 trillion dollars of cash available to the repo market. The key thing to remember here is the Fed is not spending $1.5 trillion dollars, think back to the story of Jimmy and Max I shared earlier.
This announcement simply means that banks and other financial institutions can give the Fed treasury bonds (technically any Treasury security but let's keep it simple), and the Fed will give them cash that is close too but still less than the value of the treasury bond.
In a short period of time (one or three months), the financial institution must pay back the Fed for the loan plus interest. If they do not pay back the money, the Fed keeps the treasury bond, which was already worth more than the cash given out.
Then yesterday the Fed made a new announcement, essentially throwing out the $1.5 trillion dollar cap they previously announced and saying they would buy as many treasury bonds are necessary to keep institutions afloat, and will also buy other forms of debt such as mortgage-backed securities, which are packages of mortgages put together by a bank.
Both of these moves, known as quantitative easing, have never been done before at this scale by the Fed, and as such they introduce considerable risk to spiking inflation rates, but we’ll save an explanation of inflation for another time. It should be said though, quantitative easing is one the most powerful tools the Fed has to get more cash into the market and avert a crisis.
Now- you might have reached the end of this wondering why the Fed is able to so easily bail out Wall St, while the rest of America is quite literally screeching to a halt because of the ongoing pandemic and economic fallout. It’s a great question.
Ultimately, the Fed is only responsible for monetary policy. This means the Fed is tasked with trying to control for things like inflation or interest rates. The Fed is a central bank, not a legislative body, so it does not make fiscal policy, and given that its leadership is not elected directly by the people that is probably a good thing.
If you rightly believe that in this great time of need we need a real stimulus package that gets money quickly into the hands of American families and small businesses, and not a slush fund for big corporations with no accountability over executive pay or stock buybacks using taxpayer money, you should call your elected officials and tell them that. The number is (202) 224-3121.
The financial system is horrendously broken, unnecessarily complicated, and built on layers of absolute nonsense financial products that make our economy so risky whenever we hit a bump in the road like this. But until things change there is a good argument for what the Fed is doing, the last thing we need right now amidst this global chaos is banks collapsing and needing bailouts.