So in the last couple of posts I have reviewed the origins of how credit came to exceed what banks have in capital reserves: either by selling debt to investors to free the balance sheet (in the case of securitized loans), or attracting capital from short-term bond investors through structured investment vehicles (SIVs).
To review, securitized loans came to an end when the credit default obligation (CDO) market dried up and banks could no longer insure their riskiest unrated tranches of subprime securities. That happened as subprime adjustable rate mortage loans began to re-adjust en masse, borrowers foreclosed, and subprime CDOs quickly became worthless. They went so sour I doubt there is a market even for prime CDOs nowadays.
SIVs came under distress when buyers of commercial paper went elsewhere. Why they did that is not as apparent; however if banks have mortgages at 6%, and the Fed overnight rate is over 5%, and treasuries and other bonds follow the Federal funds rate, AND (according to the principle of the carry trade) banks need to borrow-low and lend-high, perhaps commercial paper was no longer competitive. Perhaps banks could no longer sell commercial paper at rates low enough to profit.
These events happened in the Fall of 2007, and created a sudden and urgent situation where banks could not find the capital to generate new loans and were barely able to manage the ones they had.
Now, the Fed cannot increase deposits by making people save more. But the Fed can, and is, managing a government variant of the commercial paper market. First, they enacted a series of striking cuts that brought the overnight rate from 5.25% in September 2007 down to 2% in April, which makes commercial paper again a more feasible source of capital to banks—naturally at a cost to bond investors who suffer lower returns. Second, they instituted term auction facilities (TAFs), which essentially behave as a government-sponsored replacement for commercial paper buyers. So, instead of going to bond investors, banks can go to the Fed and buy the government’s equivalent of commercial paper at rock bottom rates, and up to $75 billion of it, cycling, is where it now stands. Even more, the Fed has been accepting questionable debt as collateral for this money. So if banks default the Fed is holding on to unrated subprime debt packages; while U.S. taxpayers are still liable for the treasury bonds the Fed handed out in return.
So now we have the Fed accepting the role traditionally held by bond investors, and insured by the United States tax base. What this means is that for people who want to save their money, interest rates they can get for it are being actively suppressed by government, all for the benefit of the banking industry. Saving money is not as appealing as it would otherwise be, thanks to the Fed.
However, these interventions only stopped the financial market from collapsing—it still remains under stress. As discussed before, as people borrow less, and the inventory of goods for sale remains approximately the same, the value of cash will strengthen.