Free Market vs The FedAs of late, the vast majority of us probably have been hearing about "too big to fail" or " a free market vs. a central market" What does all of this mean?"
Well, let's go over some of the basic stuff. As in some of my prior posts, it is important to understand that the "Fed" does NOT control mortgage rates or loan rates from your local banks. Let me repeat that the Fed does NOT control mortgage rates or consumer loan rates
So now you might ask yourself why the Fed raises rates matter?
Well, that's a great question. Because, in short, it should not matter if we were in a free market. Well, sadly, we are not in a free market. We are in a centralized market with different flavors available to us.
"Ah, but Guy, you just contradicted yourself by saying the fed does not control mortgage rates, and now you're saying we're in a controlled market rabel rabel rabel "
Let me explain... The Fed cannot have any direct contact with "average" consumers; it's currently illegal FOR NOW . Now, everyone, the biggest fear with CBDC is a rightfully placed fear. And we will discuss this in a separate post.
So, view the Federal Reserve's manipulation of the economy as a game of pool (billiards) or snooker; what have you. In billiards (for the purpose of the post, billiards = pool), the player cannot directly hit the numbered balls with the stick (cue). Instead, one must use a medium to engage the cue ball. So, to pocket your balls, you must have a small degree of understanding of physics to transfer energy from you to the stick to the cue ball to the desired ball into the desired pocket.
The Fed (cue) is the same way. They set the FFR (cue ball), which then goes to the regional and big banks (numbered balls), which then sink into the economy (pocket)
So, how does this work? To explain that, you need to understand how a bank makes money.
(The Following is highly watered down for simplicity's sake)
A bank does not make money because you have an account with them. On the other hand, a bank makes money BECAUSE you have an account with them.
So when you use your local JPM, WFC, or C bank :) as a piggy bank, they pay you an interest rate of something like a percent of a percent; however, it's still considered a liability to the bank because that's cash flow going to you from them even if it's a penny a year.
So, how can they make money then?
The fractional Reserve system. Mike Maloney debates this, and I'm super interested in hearing his thoughts on this... another post for another time.
What is the Fractional Reserve System? Basically, for every dollar you put into your account, the bank can lend out 10$
It's basically in place because you're not running to the bank to close your account. So, they can do this. When you put money into your account, it's already out the door into someone else's pocket in the form of a loan by the time you place your wallet in your pocket/ purse what have you. And that's probably too slow for the bank. (velocity of money)
Well, that bank's balance sheet of physical liquid cash probably only is enough to pay the onsite staff hourly wage the bank needs more. so they have one of two options
1. go to the Fed and borrow money at the FFR
2. go to the repo market and borrow from another bank by offering t-bills and bonds as collateral. (shadow banking)
Typically they go with number one because it's cheaper.
The vast majority of times they use the repo market is for cash now! or if their risk management department is trying to make some quick cash off the bond market. (shadow banking is outside the purview of this post, and I'm still learning about it. I will post about it later)
( the fed lining up their billiard shot) So, the Fed has decided the US economy needs to grow more...
(the Fed hitting the cue ball) So, lets say the Fed makes the FFR 0% (hypothetically LOL)
( the cue ball hits the numbered ball) So your local JPM will go to the Fed and take out a loan at 0%, so they need to lend this money out and make money, and make their, JPM's rate, interest rate on that money 3% LOL!
(The numbered ball sinks into the desired pocket) you the consumer want to go out and buy something you can afford on your 9-5 salary.
So you go to the bank and qualify for a loan at their 3% rate to be amortized over 10-30 years, and the economy grows.
If that sounds familiar its coincidence LOL
However, in a free market how it would work is the loan system would be heavily dependent on the local economy and local wage potential.
How?
If a bank is set up in an area with low-income earning potential, then the market will tell the bank exactly how much they can charge on money.
Example: let's say the Risk Manager at your local WFC decides he is conservative and makes the DTI Ratio for loans 30%. That means the minimum someone must make for a 200,000$ loan is around 60,000$. If the local median income is 45,000$, no one can afford a 200,000$ loan. The maximum loan amount they can make is around 150,000$.
So, for the bank to grow, it either needs to up the DTI requirements, it needs to be content with its current earnings and hope the area grows or wages increase, or it can close down and move.
Now where the free market comes into play is when WFC is having their DTI at 30%, JPM is at 40%, and C is at 60%, (free market remember) in the same area as the example
The following happens:
WFC sees their default rate is less than 10%
JPM sees thier default rate at 40%
C sees thier default rate in the upper 80%.
So, what this means is that the market is telling WFC they are leaving money on the table but are playing it safe. Because less people qualify for the loan
JPM has almost found the sweet spot. 40% of their loans are in default, but more than half are paid on time. could use some minor tweaking but solid none the less. (With my risk tolerance, 30-35% default is a good number depending on loan size.)
C is in trouble because they have lent out too much, and people can't afford that much money in the area.
So in a free market, WFC will fail in the area because they're not seeing enough volume, and C will fail because they're seeing too much volume. which leaves JPM to buy up both of the failing banks and grow bigger LOL!
