What the Fed?: Easy Money for Banks

The Federal Reserve is quietly trying to squash an arbitrage opportunity it unwittingly helped create for banks.
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The

Federal Reserve

is quietly trying to squash an arbitrage opportunity it unwittingly helped create for banks.

The Fed on Friday bought $12 billion in

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

debt obligations, just four days after Chairman Ben Bernanke had made note of how the government-sponsored enterprises were undercutting the central bank's target federal funds rate of 1% by lending money at a cheaper rate.

"

Several factors have served to depress the market rate below the target," Bernanke said in a speech to the Greater Austin Chamber of Commerce in Austin Texas on Dec. 1. "One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target."

The Fed recently started paying banks 1% for reserves they keep on hand at the central bank. But there is little incentive in this risk adverse environment for banks to lend if they can borrow money for less than what it is earning on reserve at the Fed.

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Fannie and Freddie, which the federal government placed in conservatorship in September, do not earn interest from reserves at the Fed and are hampered by a largely illiquid debt market. To fund their businesses, the companies have resorted to overnight lending -- sometimes for less than the federal funds target. The Fed's move to step in and buy that debt is perhaps aimed at moving the GSEs to lend at the target rate.

Fannie Mae spokesman Jason Lobo did not respond to respond to questions about what rate Fannie is charging or to whom it is lending, saying only, "We don't go into that level of detail." He referred to a page from a third-quarter regulatory filing showing Fannie had $33.4 million in federal funds sold and securities purchased under agreements to resell at the end of the third-quarter.

Banks don't want to admit they are utilizing this sweet arbitrage opportunity, and why would they? But several industry sources acknowledge that it would be easy to do. Let's say Fannie is lending money at 0.5%. The bank in the middle borrows from Fannie at 0.5% and then gets paid 1% from the Fed on excess reserves, pocketing the 0.5% difference.

While Bernanke is unhappy about the federal funds rate target being undercut, the Fed seems unwilling to do much about it.

Asked why the central bank didn't push to stem the sale of federal funds on the cheap by companies under the government's control, spokesman Andrew Williams of the New York Federal Reserve said only, "I stand by the statement Mr. Bernanke made."

So unless the Fed is willing to continue to pony up cash to buy unwanted GSE debt or take a tougher stand against the mortgage giants, easy money for the banks will be there for the taking.