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Why The Fed’s Outrageous Gift To Foreign Banks—- Risk Free Aribitrage

August 22, 2014
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Source: David Stockman

This profit stripping operation is simple. Foreign banks on Wall Street borrow from money market funds at an infinitesimal 3-6 basis points and then shuffle the loot down to 33 Liberty Street where the New York Fed pays them 25 basis points on the same funds. This gift is known as the IEOR payment for excess reserves. It is a short-term trade which is rolled-over day after day and is absolutely risk free. Both ends of the arb represent money prices that are administered by the Fed, not set by price discovery in the market.
Indeed, as part of its “open mouth” communications policy, the Fed promises to give considerable advance warning as to when the yield on IOER and also overnight money market borrowings is going to change. Accordingly, any foreign bank caught napping long enough to run afoul of a well-telegraphed Fed change in the arb would likely be
operating on pre-telegraph technology. That is to say, this Fed sponsored arb is tantamount to owning a printing press. All it takes is a banking license from the state of New York or other US jurisdiction.
And, yes, the parent bank owning a license to print profits in this manner should be domiciled outside the USA. That’s because foreign banks are generally not subject to FDIC levies designed to fund Uncle Sam’s deposit insurance programs—-fees which would bite into the risk free arb described above. By contrast, domestic banks which pay the FDIC fees are largely not involved in this particular free money gambit.
This seems like a screaming outrage that couldn’t be true—especially because the real beneficiaries of the Fed’s largesse are Europe’s giant banks which are insolvent but socialized wards of the state. But, alas, no less an authority than the Fed’s own unpaid spokesman, Jon Hilsenrath of the Wall Street Journal, confirms that this entire larcenous arrangement happens day-in-and-day-out on Wall Street:
The most striking feature of the Fed’s strategy is that it keeps in place an effective subsidy that the U.S. central bank is currently paying to foreign banks.
Here’s how:
In recent years foreign banks have been tapping U.S. money market funds for very cheap short-term loans. Unlike domestic banks, foreign banks don’t have domestic depositors to tap for funds, so they turn elsewhere for dollars. Money market funds make the funds available for a few hundredths of a percentage point. The foreign banks in turn park those loans at the Fed for 0.25% interest. They earn profits on the spread between the cheap cost of funds available from money market funds and the higher rate they get at the Fed.
It’s a trade that domestic U.S. banks have been unwilling to make because they have to pay additional fees to the Federal Deposit Insurance Corp. on their borrowings, fees the foreign banks don’t have to pay.
Here’s the thing, however. The profit capture by foreign banks is only the tip of the iceberg of financial deformation that has been generated by ZIRP and the Fed’s whole hog domination of financial markets where honest prices for money, debt and risk assets were long ago extinguished. In this instance, ZIRP has caused $2.6 trillion in money market mutual funds to be sequestered in financial limbo where these funds earn virtually nothing in the Fed administered money market.
Moreover, upwards of $1 trillion of this total is in retail funds where grandpa is today collecting 3 basis points at the PNC fund and 6 basis points at Schwab. In a word, this is willy-nilly income redistribution on steroids. Fed policy functions to sweep the assets of main street’s liquid savers into what are essentially ZIRP accounts. Having accomplished this un-voted tax levy on millions of US citizens, it then sponsors a profit stripping scheme for a handful of foreign banks which use these ill-gotten windfalls to augment their grossly deficient capital levels, thereby reducing the bailout exposure of their socialist wardens in Brussels and throughout the EU capitals.
And it doesn’t stop there, either. How does the Fed earn the money to participate in this off-balance sheet foreign aid program?  Why, from you and me—the taxpayers of America.  The Fed is now earning upwards of $100 billion per year on its swollen $4.4 trillion asset base—–a trove of Treasury and GSE debt that was funded by hitting the “buy” key on its digital printing press. Our taxes then pay the interest on all those Fed assets—-giving the monetary politburo in the Eccles Building nearly infinite walking around money for schemes of this sort.
Undoubtedly, Fed apologists would argue that this subsidy to foreign banks is a modest, collateral effect of god’s work performed by the FOMC as it deftly manages interest rates and other financial levers to shepherd labor markets and national output to the promised land of full employment and potential GDP. But that justification, in fact, is the essential and everlasting indictment of the entire enterprise of monetary central planning.
Free markets always and everywhere liquidate mis-priced spreads among financial assets, meaning that windfalls like the foreign bank subsidy are rapidly arbed-out. By contrast, central bank financial repression and interest rate pegging defeats these beneficent market forces and, instead, locks-in arbitrage opportunities that linger indefinitely. Indeed, the foreign bank subsidy is just a faint example of the carry trade dynamic which infects the entire financial system.
Just as the Fed instructs foreign banks to “come and get it” with its locked-in IOER/money market spread, it delivers the same message to the entirety of what has become the Wall Street gambling casino. By means of ZIRP it decrees that the cost of funding speculative portfolios is virtually free. At the same time, its explicit and aggressive commitment to asset price appreciation and “wealth effects” levitation of jobs and GDP has generated a massive one-way bid for assets like junk bonds with a yield or stocks and ETFs expected to appreciate. And like the foreign banks here essayed, Wall Street gamblers laugh all the way to the bank as they put on both sides of the Fed’s profoundly anti-market trade.
And this awful system of windfall gifts to speculators, and the capricious redistribution of wealth from savers to gamblers on which it depends, will not go away owing to the pending end of QE or the hinted at baby steps toward normalization of interest rates. The heart of the evil is interest rate pegging itself. That is, the replacement of market prices with administered prices—direct and indirect—throughout the financial system.
As Hilsenrath also explains the Fed intends to trap the money market in a 25 basis point corridor between the IOER and the offered rate on its reverse repo facility. If that corridor is set at a spread between say 25-50 basis points initially, or is even ratched-up in Greenspan like baby steps for years to come, the Wall Street carry trade is likely to remain in place for a considerable time. What counts is the certainty that near-term funding costs are fixed at rates which generate positive carry against the return on risk assets.
Now that is the essence of Fed policy. An all-powerful, un-elected arm of the state has transformed itself into a crooked croupier and has no intention of leaving the casino.

David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

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