Benefits of loans
Loans are a convenient way to acquire assets that don’t have an immediate economic benefit, but which can provide long-term liquidity, and in this case can help finance long-term growth.
The Federal Reserve has provided a lot of aid to banks that are facing the difficulties that have been occurring in the real estate market. What will be the effect of the Fed’s purchases of mortgage-backed securities on the mortgage market?
One important part of the Federal Reserve’s purchase of securities is to provide short-term liquidity to the market. There has been a lot of talk that short-term liquidity would have a negative effect on mortgage lending, and I’m not sure how that would work.
Short-term liquidity is a function of two factors: the current cost of short-term debt and the time lag between payments to the banks on their short-term debt and the maturity of the loan. The cost of short-term debt was high because banks had borrowed a lot of it, and the time lag from the original transaction to the payment of the debt was very short. In effect, the Fed created the demand for more short-term debt, and as the demand grew, so did the costs to banks, so banks were reluctant to extend more credit. Thus, the price of short-term debt was low because the government kept the banks from raising their rates. In effect, the Fed was creating an artificial demand for short-term debt, and that’s why there are services that can help people getting loans quickly and you can check out this site to find more about this.
Now to understand this effect, let’s look at the real cost of the debt: what it costs the Treasury to issue it.
The Treasury issues long-term debt at interest rates ranging from 1.5% to 3.5% and then pays the banks (by charging them for their loans) a variable rate of interest based on the number of months a loan will be in force (i.e. the maturity). The average interest rate on long-term Treasury debt is between 4% and 5.5% per year, with some periods of interest rates higher than 4%. Interest is paid on the difference between the market rate (the interest the government gets paid to borrow money at) and the cost of the loan (the interest rate the banks pay for the loans).
The longer the maturity, the higher the rate of interest the Treasury has to pay. Treasury bonds are issued by the US Treasury. In recent years, long-term Treasury bonds have traded between around 2% and 3%. The yield of long-term Treasury bonds, the interest rate the Treasury pays for the money the government spends, is determined by the Fed.
Since long-term Treasury bonds are sold on the market, their prices can fall (in response to falling interest rates). The Fed sets interest rates, and the Fed controls the volume of money in circulation. The quantity of money in circulation is a function of the government’s budget deficit (what it spends) and how that deficit is financed (what it borrows). Since the Fed sets interest rates (and so controls the volume of money in circulation), it controls what people think is a safe level of the money supply.
As the government spends more than it takes in in taxes, people are tempted to spend more than they have. The more the government borrows to finance its spending, the more people think the money supply is growing rapidly. As the government spends more than it takes in in taxes, the government’s balance sheet becomes overly large.