Audio Interview with Wendy Kowalik, Part I – On Fees

Wendy_kowalik
Wendy Kowalik of Predico Partners

Here’s Part I of my interview with an investment consultant who charges advisory fees in an unusually (admirably!) transparent way. Click on Part II and Part III to hear Wendy and I discuss the uses of insurance, the psychology of savings, and how to get rich slow. You can read the transcript but as always I recommend the audio version highly!

 

Michael: Hi, my name is Michael and I used to be a banker.

Wendy: Hi, Michael. Wendy Kowalik, I founded Predico Partners. We’re a financial consulting firm.

Michael: Wendy, thanks so much for talking about that. There’s lots of different interesting things to say about your business, but I wanted to start with costs, because I think cost is one of those topics people don’t know that the most important thing to ask your investment advisor, in my opinion, is “how do you get paid?”
You have a different cost structure than most investment advisors. Can you tell me about that? and then I may jump in as well about that.

Wendy: Absolutely. What we found over the years is that most typical cost structures are built where someone brings you assets, and you’re going to charge a fee to oversee them, and invest them, and that’s how everyone gets paid. There’s a thousand different pieces of the puzzle beneath that.
What we decided to do at Predico is to go about life a bit differently. We decided we’d do an hourly charge for clients because it didn’t matter how much money you had; it was more about the time we were spending to either help you find someone to manage your money, or help you find some place to take care of it from there.
We do it based on a project fee or hourly fee.
In 2008 we had a client that had lost a lot of money, when we were in the former investment management business. And one of the things they sat back and asked was: “Do you get paid to keep me in the market or do you really believe that if I get out of the market that you could still make money and help me out?”
We decided we wanted a conflict-free answer to that question. And as we also looked at it, we had clients asking us “If our value went from 10 million to 20 million dollars are you really doing that much work for me than you were doing when it was at ten?”
The answer was no, from our perspective.

Michael: That is the main question. It’s basically as much effort to manage somebody who’s got 100,000 dollars, a million dollars, or 10 or 100 million dollars. As a manager, the scalability of charging fees on assets is so freaking amazing that it’s really unusual that someone would say I’m going to charge — you’re charging analogous to an attorney or a CPA, who would say charge me for the project by the hour, not on percentage of assets. It’s very unusual.

Wendy: Correct.

Michael: It’s almost to the point of you’ve chosen the hardest way to try to run your business, versus the scalability of “Hey, if I get a couple clients who have ten-million bucks I’m pretty much in business and I’m good.” As an investment advisor, it’s a very scalable business that way.

investment_advisor_fees
What should be on every investment advisor’s wall

Wendy: That’s a very true statement. I tell clients that all the time. If you look at investment advisors they have two ways of making money. The first way is the way they’re going to market to you, which is “I make money if you make money. I grow my practice by growing your assets. That’s why we should do it this way.”
The other way is the way that most of the investment business works is I make money by getting as much assets under management as possible, so even if a market goes down, if I picked up four more clients with assets, my income has still gone up this year.

Michael: And you haven’t chosen either of these awesome ways to make money!

Wendy: for 17 years of my career I did, and I did that, and we made a really good living by managing peoples’ money, and selling them insurance. I found it wasn’t a comfortable model for me. I was uncomfortable that I was either overpaid for my time for certain clients, and underpaid at other times. I decided I just wanted to get paid for my time, in a manner that both of us could see clearly the only person writing me a check was the client. And yeah, it’s definitely a much tougher model to track your hours, but I think it’s the fairest model, and I can sleep at night when I put my head on my pillow.

Michael: A client writing a check, versus what everybody else does in the investment management world, which is I just quietly slip out a portion of your money on an annual or quarterly basis, and you never even feel the pain of losing that money. When somebody has to write a check upfront for advice they’re given, it’s just a much higher hurdle.
I think it’s sort of magical the way that most investment advisors sort of slip the money out quietly, and you never notice it.

Wendy: Very true statement.

Michael: It’s magical little part of the compensation scheme that we call investment advisory, and you’re not doing it.

Wendy: And what they teach you over time when you’re in the investment management business is “It’s going to be just like gym-membership fees. Everyone signed on to the gym, they never go, and the gym keeps collecting it.” Same thing with an investment advisor.

Michael: Neglect is a key part of a lot of business strategies, gym fees, and a lot of insurance is built around the idea of neglect. You’re not going to re-check.
On a side note, my wife and I were looking at her mutual fund choices this week, and I noticed she’s got a bunch that are fine choices in terms of risk, but they’re probably five times the fees as probably she needs. It’s been going on for ten years. I looked at it and I said, “Oh my gosh, I can’t believe you have these high-cost mutual fund fees.” She said, “You’re the one who told me to do it.” I was like “That’s right, ten years ago.” I’ve neglected for ten years to check whether she’s still in these high-cost mutual funds. There’s a lot of money involved, even at our scale, that over time those mutual-fund managers have earned, simply from neglect. I just forgot to check.
Meanwhile, I’m out there pounding the gavel for people “You’ve got to be in index funds, or lower your costs, and don’t overpay these managers.” Meanwhile, my wife’s retirement account is paying a lot of fees, and I’m the one to blame, as she pointed out correctly.

cobblers_kids
Cobbler’s kids have no shoes

Wendy: “It is the cobbler’s kids” [“that go barefoot,” I guess] That is a very true statement It is amazing how easy it is to ignore, and it makes you realize how tough it is for clients to do it. There are many times clients say “I can’t believe I’ve let this go on. I’m so embarrassed I haven’t looked at this, or I didn’t know.” We all run into the same point. You’re busy making money for the company’s bottom line. The last thing you look at is your own bottom line.

Michael: It’s hard. I know you know — I don’t, but you’ve done this; it’s hard to get somebody to say pay me money now, upfront, for some future benefit, rather than “I will keep getting paid on a renewable, quiet, stealthy fee, year after year after year.” I admire it. I’m amazed, actually.
Wendy: Thank you. It was definitely — I was very concerned about it when I launched the model because that was what most people told me. I just don’t know that I’d be comfortable, but I found people really like the fact I have no conflict, that I can sit in a room with an investment advisor and help them interview, and ask the questions because we did sell it for 17 years. I really do know why they’re being shown a certain thing or why not. It is fascinating to see all the things that are second nature, after you’ve been in the business, that you wouldn’t even think to tell a client, and watching that evolution come out.

Michael: Somebody comes in to you and they have a modest 50,000 or 100,000-dollar portfolio versus somebody else comes in and they say “I just inherited 15 million,” are you charging essentially very similar amounts for the same service?

Wendy: As I tell everybody, we charge $250 an hour and we’ll sit down and estimate the number of hours to get you an ideal project fee. So, yeah, in answer to that question. If you want us to go through, the only difference should be if you only have 50,000 dollars and two managers, helping you review it and ask some of the questions is a lot less hours, so it should be a lot less charge than it would be if I’ve got 32 accounts.

Michael: Somebody comes to you and you’re going to put together a plan. They may certainly end up paying mutual-fund or hedge fund management fees, and then they may end up paying fees to an insurance solution on top of what they paid you. They’re not eliminating that. It’s just they’re getting that presumably without the conflict of your caring, in a sense, about who they go to. Is that accurately said?

Wendy: Right, we do not manage money so once they actually decide they want to go put that money to work, we’ll help them find somebody if they need help or we’ll review what their current investment advisor is proposing. But yes, they’re going to end up paying some form of fee. The goal is we’ve helped them negotiate those fees down as low as possible, or we help them find somebody that they feel very comfortable, and trusting that they’re in good hands if they’ve never done this before.

 

Please see related posts:

Do you need an Investment Advisor? And Why?

Management fees – My Hyundai Elantra analogy

Book Review – A Random Walk Down Wall Street, by Burton Malkiel

 

 

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Video: WSJ on Wealth Inequality – Causes and Solutions

wealth_inequalityI happened upon this excellent little video put out by the Red Communists who run the Wall Street Journal today. Since I think:

1. Wealth Inequality is a Top 3 issue facing the US and the World;

2. I’m in favor of everything that adds helpfully to the discussion;

3. We all have a hard time agreeing on basic facts about the causes and extent of wealth inequality (never mind the solutions!) and calm presentations like this are therefore particularly welcome!

 

Please see related posts

Video: Visualizing inequality

Inequality in America – The Map

Video: A Ted Talk by a Plutocrat on Inequality

Book Review: Plutocrats by Chrystia Freelander

Video: Chrystia Freeland Ted Talk on Inequality

Book Review: The Price of Inequality by Joseph Stiglitz

 

wealth_inequality

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A Leader for San Antonio: Mike Villarreal

mike_villarreal_best_candidate_for_mayor
Mike Villarreal studies the data

I have something to say about the San Antonio Mayor’s race. My friend Mike Villarreal is running and he is by far the best candidate. He supports data-driven financial policies (rather than platitudes and rhetoric), he listens and acts across party lines and for the good of the whole (not just one constituency), and he’s an SAISD dad who know how important educating the next generation is to ensure long term financial future of the city. Please bear with me a bit for a meandering story about my friend, New York City, and the movie Jerry McGuire.

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Unflattering picture of everyone. But you want the guy on the right

Fun with data analysis

Mike called me up one Saturday, about two years ago.

“Hey, can we meet for coffee?”

“Sure.” (Duh. I’m easy – a coffee addict.)

“I want to show you a project I’ve been working on with my laptop.”

We ordered coffee at Halcyon in the Blue Star Arts Complex. He proudly toured me through the statistical regression model he’d spent the week programming on his computer. He excitedly pointed to the results of his model, indicating pockets of properties where property taxes were higher or lower than average – statistical outliers. What if we could apply these techniques at the city, county, or state level?

When we get together with our families for lunch or dinner, my wife and Mike get into intense conversations about statistical techniques. I can follow the conversation for a short while. I get a teensy bit lost when their statistics chat turns to the z-score, chi-squareds, or p-value.

Prove your ideas

Personally, I prefer making sweeping declarations based on a few pieces of partial evidence. I’m good at that. I guess that’s why I enjoy this column-writing gig.

My wife – more of a scientist-type – accuses me of grandiose pontificating based on little data. My response to her critique (only when she’s out of earshot): “Whatever.”

But my data-oriented friend Mike also frequently (though more politely) challenges my sweeping declarations.

“I liked what you wrote in the paper, but couldn’t you get some actual data or evidence to see if you’re right or not?” he asks me.

Or, “So, how would you go about proving that?”

A mayor I admired

Speaking of public policy, I think fondly of a favorite mayor of my lifetime, Mike Bloomberg, who led New York City for eight years when my wife and I lived there.

Mike_Bloomberg_data_driven
I liked Mike Bloomberg’s disregard of political parties alot

Bloomberg was a Republican in a Democratic-dominated city. What mattered to me, however, was that he led New York for twelve years practically without reference to either party. Which is how a city should be run.

Bloomberg famously relied on data analysis and best business practices. He didn’t need to act out of ideology or loyalty to one party or another. Rather, when making decisions, he considered what worked best for the city.

Bloomberg showed that while Washington, DC stagnates with tired ideological gridlock, cities can innovate.

Why am I thinking of Bloomberg?

Mike Villarreal approaches policy as Bloomberg did. From the beginning of his campaign, Mike’s been fired up about the chance to lead the city in a non-partisan manner. “We don’t need a Democratic Party or Republican Party here, we need the Party of San Antonio” he told me last summer, when he focused one hundred percent of his efforts on running for this office.

To lead a diverse, growing, dynamic city, we need a leader who looks at all the evidence, weighs the choices, and makes the best decisions accordingly. We really don’t need a mayor who represents a limited party view, or a limited geographic base, or a limited identity.

Many talents

Beyond data-analysis, Mike has a number of talents that I admire.

I’ve watched him listen to people of all ideological stripes. He convenes alternate sides of an issue at the same table to listen to each other in search of common ground.

He takes political risks that more careful politicians would avoid, standing up to powerful forces – particularly in his own party – when it was in the public interest.

He understands first-hand the struggle of families pouring everything they have into raising children in this city. He grew here, his family did this for him, and he’s doing it for his own kids.

He’s a passionate competitor at board games, and a fired-up soccer dad.

But I guess what I admire most is his constant return to real, data-based evidence to back up policy ideas and ideals.

Antidote to cynicism

The worst thing about politics these days is our cynical belief – often borne out by experience – that our leaders make decisions based on campaign contributions, a perpetual “Show me the money!” mantra on their lips.

show_me_the_data
Mike is like the Cuba Gooding or Tom Cruise character: Show Me The Data

In a goofy way, I picture Mike in future policy meetings as a better version of the Cuba Gooding Jr. character in the movie Jerry Maguire. I picture him shouting in response to city lobbyists:

“Hey Mike, can I talk to you about my group’s housing agenda?”

“SHOW! ME! THE! DATA!”

“Excuse me, what San Antonio really needs for economic development…”

“SHOW! ME! THE! DATA!”

“Mr Mayor, the school district would like to request…”

“SHOW! ME! THE! DATA!”

OK, OK, Mike is not a yeller, so the analogy is not a perfect fit.

But if Mike Villarreal is the Cuba Gooding character for public policy, I guess that makes me the Renee Zellweger-character of financial columnists:

“Shut up. Just shut up. You had me at data-driven financial analysis.”

I know Mike will be a great Mayor for San Antonio.

Early voting begins April 27th. Please vote.

 

Please see related post from blogger, Concerned Citizen:

There’s a better choice for mayor of San Antonio – Mike Villarreal

A version of this post ran in the San Antonio Express News

 

 

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Lord of The Rates Part IV – Consumer Rates

nazgulI’ve reviewed in recent columns what I believe happens when interest rates rise this Summer, in particular what happens to real estate when the FOMC raises the Fed funds rate, Aka “The One Rate To Rule Them All.”

 

“…Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born…”

 

While rate hikes generally hurt, I don’t expect this rate hike to change much for consumer interest rates.

Consumers already face a very wide range of interest rates, from 2% Prime auto-loans, to mid-range consumer debt at less than 10%, to the mid-20% for credit card debt, even to stunning 100%+ annual rates for payday loans.

Just as the humans of Middle Earth experienced vastly different Rates of Power, so too do we humans of this Era already face vastly different rates.

I’ll review these different ends of the consumer-borrowing spectrum in turn.

Cheap Prime rates disappear

The very cheapest consumer loans may jump a bit this Summer.

Locking in cheap student loans, mortgages, and auto-loans in this Era left us feeling like the Dúnedain, noble and heroic borrowers.

Credit Unions that offered 1.9% auto loans probably stop doing so immediately following the jump in rates. Historically low rates spurred auto purchases, making us Riders of Rohan, racing across the plain on our fresh swift horses.

In addition, low rates like my 15-year mortgage at 2.75% probably cease being available. In retrospect, those rates will mark a low-tick of the interest rate market.

For a high credit borrower collateralized by a car or home, however, we’re probably only looking at a 1 to 2% jump after rates rise.

Uncollateralized personal loans for high credit borrowers – like you can see on a crowd-sourced lending site like Prosper.com – currently run in the 6 to 8% range. Those rates likely jump a bit as well following the Fed funds hike this Summer.

prosper

Credit cards

Moving a bit higher on the consumer interest rate scale, I doubt credit card rates move much at all.

Your basic credit card rate balance already charges substantially high rates. The national average credit card rate on balances runs around 15% right now, which is high enough to leave your finances feeling as woozy as King Théoden under the influence of Wormtongue.

And that’s just the average. The highest rate you will see quoted nationally is 29.9%, although penalties and fees can push effective rates higher than that. As long as they can limit defaults, banks don’t really need to raise credit card rates above 15% to 29% to stay profitable, when the Fed funds rate rises.

What about those seemingly attractive 0% interest balance transfer requests that come in the mail? Will those go away when rates rise? I doubt it.

0% balance transfers

Credit cards offers to consolidate balances at 0% for 6-12 months probably continue even after rates start to rise, because these aren’t really 0% loans.

In the fine print of most of these so-called 0% offers is the requirement that you pay an upfront 3% ‘consolidation fee’ for the privilege of a supposed 0% balance transfer. When you translate the 3% fee into an annual rate, you get something not at all close to the advertised “0% loan.”

How is this not really a 0% loan, but instead is a nasty trick perpetuated by a Saruman-like wizard, in the service of the Dark Lord? Let me explain.

saruman

If you transfer a high interest $10,000 credit card balance on which you had been paying, say, 18% per year, it is true you would cease having to pay $150 in monthly interest on your balance.

You would instead pay an upfront 3% fee of $300 (on the $10,000 balance in this example). Even if you paid off that loan after six months – before the 0% rate goes away – you’ve already paid an effective 6% annual rate. Credit card banks will happily take that initial 6% rate when they know they’ll most likely have you paying something like the old 18% on the balance, when the six months is over. Since you’re really paying at least 6% rather than 0%, I think banks will find it worth their while to continue those supposed 0% balance transfers.

But that’s not the worst consumer loan ever.

The Nazgûl of Lending

Payday loans – the Nazgûl of consumer lending – obviously can’t go higher from here. These loans, higher than 100% annually, prey from above on the finances of the people below. These are shrieking nails-on-chalkboard black-winged creatures.

Even Yellen in the land of FOMC cannot push these rates higher.

I just looked up a payday lender online and found I could borrow $500 for 30 days, and owe $629.92 at the end of the month. That’s a 315% annual borrowing rate.

The good news? (He said, ironically.) That rate is not going up this Summer, either.

Please Éowyn, or somebody, put a sword through the crown of these undead creatures.

 

Please see related posts

Lord of the Rates Part I – One Rate To Rule Them All

Lord of the Rates Part II – On The FOMC ‘Printing Money’

Lord of the Rates Part III – The Mortgage and Real Estate Market

 

 

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Lord Of The Rates Part III – Mortgage and Real Estate Market

Rivendell_mortgage_bankers

A version of this post ran in the San Antonio Express News.

Please see related posts: LOTR Part I – One Rate To Rule Them All,

and LOTR Part II – How Money Is Born

and LOTR Part IV – Consumer rates

Three rates for mortgage brokers under the sky…
One for the Yellen on her dark throne
In the land of FOMC where the money’s born

The mortgage bond market sets the major interest rates we experience as real estate purchasers and mortgage borrowers. Because these rates are market-driven, they change from one day to the next, even from one moment to the next.

In my Lord of The Rates narrative from an earlier post the High Elves of the Mortgage Market own the 3 Mortgage Rates of Power, setting 30yr, 15yr, and short-term adjustable-rate mortgage (ARM) rates.

In an Earlier Age, I worked with those High Elves on the Goldman mortgage bond sales desk.

“Bid $1 Billion Fannie Mae 30year 5% in June”
“100-23+”
“Done.”
“Done.”

As fast as it took to read that, a mortgage-originating bank like Wells Fargo or Bank of America would promise to deliver a billion dollars worth of a diversified bundle of 30-year home mortgages, all with the same interest rate, two months from now, to Goldman’s mortgage bond structuring department. And the buyer responded with how much over face value they’d pay

The price Goldman paid for that bundle depended on an expectation of what price end-user bond buyers would pay for mortgage bonds, two months ahead.

Using Elven magic – known as securitization – our team at Rivendell would weave the dross of three thousand or so home mortgages into shimmering golden threads of valuable bonds, desired by investors all throughout Middle Earth.

That price paid – which again, fluctuated from moment to moment with the interest rate markets – ultimately drove the rate a home-buyer could lock in today.

The Fed funds rate – The One Rate To Rule Them All – anchors the interest rates that mortgage bond investors are willing to accept. And that One Rate To Rule Them All is about to go up.

Higher Rates Coming

When the Fed dropped the Fed funds rate in surprise moves in 2001, and again in 2008, mortgage bond investors accepted lower interest rates on their mortgage bonds. That lower rate allowed mortgage borrowers to save money, either by locking in new, cheaper, mortgage loans or through refinancing their existing mortgages.

rivendellUnfortunately, for home owners and buyers, we’re going the other way now.

When the Fed resets to a higher Fed funds rate – which it will do in either June or September this year – the bond investors of Middle Earth react by demanding higher returns on their bonds.

That demand for a higher return by bond buyers means mortgage originators will require future homebuyers to lock in higher rates on their mortgages. In addition, fewer borrowers will want to refinance, since they can’t save money that way.

Of course, I’m simplifying the timing. All interest rate markets are forward-looking, meaning that the probability of higher interest rates in the near term gets ‘priced in’ to interest rates throughout the mortgage system.

What I mean is this: The High Elves of Rivendell concern themselves with the future, even before it comes to pass. Professional mortgage bond investors already know rates will go up soon, so they’ve already begun to demand higher mortgage rates ahead of the FOMC’s move.

Still, higher rates will certainly affect real estate prices in the future.

Rates effect RE prices
At the risk of stating the obvious, higher mortgage rates tend to dampen the price of real estate.

Bag End for sale

With higher mortgage borrowing costs, home-buyers (as well as commercial real-estate buyers) typically can afford to buy less real estate for their money. So prices go down, or stay down, to match the newly-limited demand.

To give a quick example: A hobbit of Bag End with a $200,000 mortgage at 4% for 30 years on his burrow could expect to pay $956 per month.

That same hobbit, asked to lock in a 5% mortgage six months later – following an interest rate hike – would need to pay $1,075 per month. The $120 extra per month might be the difference between being able to afford the monthly cost of a new burrow – or not.

Since the real estate market – residential, commercial, and raw land alike – depends on borrowed money, the demand for real estate is very sensitive to interest rate changes like this.

Of course this was a huge reason why policy-makers desperately sought to keep rates low following the 2008 Credit debacle. Low interest rates provide a huge boost to real estate demand and therefore prices.

Bag End ComparablesThis in turn allowed the Sackville-Bagginses, in danger of foreclosure, the chance to work out their problems, sell at less of a loss, or deleverage their burrows less desperately.

Hopefully the Sackville-Bagginses have already locked in a low mortgage rate on their burrow, because it gets harder to afford real ownership once rates go up.

When the One Rate To Rule Them All jumps this year, the mortgage and real estate markets will be among the first to feel it.

 

Please see related posts:

The LOTR – The One Rate To Rule Them All

The LOTR – How Money Is Born

And The LOTR – Fed Funds effect on Consumer Rates

 

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Lord Of The Rates Part II – ‘Printing Money’

IsildurPlease see related posts: Lord of the Rates Part I – One Rate To Rule Them All, and Part III and Part IV.

Interest rates in the US are going up soon (maybe September? maybe June?), so what will that do to the money supply?

As the ancient text translated from Isildur bane says:

Three rates for mortgage brokers under the sky

Seven for the bankers in their halls of stone

Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born

One rate to rule them all, one rate to find them,

One rate to bring them all and in the darkness bind them

In the land of FOMC where the money’s born.

Printing money

Economists don’t like to say that the Fed ‘prints money’ since the physical act of manufacturing bills and coins has very little effect on the actual money supply available in the US Economy. The US Mint, not The Federal Reserve, creates physical coins and bills.[1]

The Fed funds rate and the open market operations used to enforce the Fed funds rate, plus the market-based reactions of large banks to those interest rates, plus the invisible hand of separate self-interested actions by borrowers in an economy, is really how the Fed ‘prints money’ when it wants to increase the money supply.

In an important sense, private banks are the ones who really ‘print money,’ with the Federal Reserve’s agreement and nudge, when they make loans to businesses, governments, and consumers through our system of ‘fractional reserve banking.’

‘Fractional reserve banking’ kind of works like this: At any given time period, a bank needs to keep available in cash only, say, 10% of its total deposits, while the other 90% is available for investing or lending.

So with your $1,000 CD for 1 year that you opened, your bank actually plans to lend out $900 of that while keeping only $100 on hand as a ‘fractional reserve’ of your CD deposit.

When your bank lends $900 to the local coffee shop,[2] the $900 is really almost like ‘printed money,’ sort of, kind of, invented by the bank out of thin air. How’s that?

gollum

You deposited $1,000, and that money still exists as yours, or at least will exist for you in a year from now. The coffee shop meanwhile has use of $900 for its own purposes. When the coffee shop then deposits, for the meantime, the proceeds of its $900 loan into its own business bank, the ‘fractional reserve banking’ system keeps on going, inventing more money.

The coffee shop’s bank can take the $900 deposit, and lend out $810 of that again to another business (again retaining the $90, or 10% fractional reserve.) Continuously lending 90% of deposits is how private banks and the borrowing customers’ create money’ in an economy.

money-creation

With low interest rates and lots of borrowing in an economy, the original $1,000 CD gives birth to much more money circulating in the economy, first $900, then $810, then $729, then $656, etc.

As long as lots of businesses, governments and consumers want to borrow money – and they generally want to borrow more when rates remain low – the money supply grows via this fractional reserve banking system.

The Fed funds rate
Returning to the role of the Federal Reserve in this process: To the extent the Fed funds rate remains low, a private bank can access money cheaply and make money relatively easy for its borrowers to access.

As long as borrowers have a need for capital, the money supply grows easily in response to economic activity, when Fed funds and other interest rates in the economy remain low.

By contrast, when the Fed funds and other interest rates rise – as they are about to do, soon – a reversal of the fractional reserve lending process occurs. As interest rates rise, fewer business and consumer borrowers may find it profitable or attractive to take out loans, thus slowing the growth of the money supply.

If interest rates rise enough, they effectively reverse the ‘money printing’ of a fractional reserve system. The coffee shop doesn’t want to borrow the $900 in the first place any more, and all that later money ($810 + 729 + 656, etc) remains ‘unborn’ as well.

That’s good for limiting the money supply and therefore inflation, but also risks choking economic activity if an interest rate hike is too high or too fast, relative to the economy’s natural demand for money.

Anyway, in simplest form, that’s the mechanism of how the Fed – via the Fed funds rate, the actions of banks, and subsequent actions of borrowers – determines the money supply.

Please see related posts:

LOTR Part I – One Rate To Rule Them All

LOTR Part III – Fed Funds, Mortgage and Real Estate Markets

LOTR Part IV – Fed Funds Effect On Consumer Rates

 

[1] For a little tangential info on the profitability – via seigniorage – of The Mint when it does create coins and bills, see this note on why I use dollar coins.

[2] Can you guess where I wrote this?

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