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Are Banks Borrowing from the Fed at Low Interest and Making Money Buying U.S. Treasuries?

Question: I read recently that the “big banks” are borrowing from the Fed at 0.1 percent and buying U.S. Treasuries with the borrowed funds, thereby collecting around 3 percent. Can this possibly be true?

Paul Solman: They have been doing just that, though of late it’s more that, thanks to the Fed, they’re borrowing from the capital markets — short-term — and lending longer-term to the U.S. Treasury. We reported this awhile ago ourselves.

What’s happening is this: The Fed is keeping short-term interest rates low and implicitly insuring that TBTF (too big to fail) banks will never F. (After Tweeting irregularly for a year or so, I’m tempted to change the shorthand to 2B2F.).

As a result of the Fed’s negligible short-term rates and implicit insurance, the B banks can borrow in the global capital markets at near-zero cost, short term. They can then take that money and buy Treasuries – i.e., lend the money to the U.S. government.

But remember, the banks are taking a risk, even lending to the Treasury. It’s the risk banks always take when they borrow short and lend long. If short-term interest rates suddenly spurt, so does their cost of money, money which they must constantly raise, since it’s short-term. Meanwhile, the banks are stuck with their long-term loans, precisely because they are LONG-term.

So imagine the following scenario. A bank has a portfolio of 10-year U.S. Treasury bonds that pay 3.5 percent a year, the rate the past few days. And now short-term interest rates – and thus the cost of money — suddenly spurts to 5 percent. It would then be LOSING money on its portfolio.

Of course, as long as it pays DEPOSITORS less than 3.5 percent, it would still make a spread on the deposits. But since depositors have the alternative of money-market funds, which invest in short-term loans, banks will have to pay more interest on deposits. You see the problem.

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