*

 *

ABOUT MEDIUM-TERM NOTES  * Since 1997 the Federal Reserve Board has been obtaining data on the issuance of medium-term notes (MTNs) from the Depository Trust Company (DTC), a national clearinghouse for the settlement of securities trades and a custodian for securities. The DTC performs these functions for almost all activity in the domestic market. Before 1997, the data was based on surveys of U.S. corporations that borrow in the MTN market. * The MTN data does not include offerings by foreign corporations, sovereigns, or federal agencies and whilst it does include MTNs offered by bank holding companies, it excludes deposit notes and bank notes offered by banks because these securities are exempt from SEC registration under section 3(a)2 of the Securities Act of 1933. The Federal Reserve collects this data to improve its estimates of new securities issues of U.S. corporations as published in the Federal Reserve Bulletin and to improve estimates of corporate securities outstanding as shown in the Federal Reserve's flow of funds accounts. The Federal Reserve regards the data on individual firms as confidential. * The Study Group carried out extensive discussions with international commercial and investment banks that are most active in the market for the main new financial instruments. The purposes were both to improve central-bank knowledge of those instruments and their markets as the situation existed in the second half of 1985, and to provide a foundation for considering their implications for the stability and functioning of international financial institutions and markets, for monetary policy, and for bank's financial reporting and statistical reporting of international financial developments. Alongside this work, the Basle Supervisor's Committee has undertaken a study of the report of the prudential aspects of banking innovations and a report on the management of bank's off-balance-sheet exposures and their supervisory implications was published by that Committee in March 1986. * The growth of these instruments has been enhanced by two influences. * Firstly, bankers have been attracted to off-balance-sheet business because of constraints imposed on their balance sheets, notably regulatory pressure to improve capital rations, and because they offer a way to improve the rate of return earned on assets. * Secondly, for similar reasons, banks have sought ways to hedge interest rate risk without inflating balance sheets, as would occur with the use of the interbank market. [Extracts from "Recent Innovations in International Banking - April 1986" prepared by a study group established by the Central Banks of the Group of Ten Countries and published by the Bank for International Settlements.] * Why should such an instrument be issued? To understand the logic behind the actual mechanics of the operation it is necessary to look at the way in which a bank usually operates. The bank's credit rating and status within society is judged by the "size" of the bank and its capital/asset ratio. The bank lists its real assets and its cash position, including deposits, securities, etc., against its loans, debits and other liabilities showing a ration of liquidity. Each jurisdiction of the World banking system has different minimum capital adequacy requirements and, depending on the status of the individual bank, the ratio over assets which the bank can effectively trade can be as high as 20 times the minimum capital requirement. * In simple terms for every $100 held in asset/capital the bank can lend or obligate ate least $1,000 to other clients or institutions against the cash on hand. * The money placed on deposit by the bank's customers is dealt with in a different manner to the actual cash reserves or assets of the bank. If the bank disposes of an asset, the reluctant capital is able to be "leveraged" using the bank's multiplier ration, based on the minimum capital adequacy requirements. * To bring all of this into focus and identify the application of these points to the matter of the question we will now make the following overview: * A bank receives an indication from a client that the client is willing to "buy" from the bank a one year obligation, zero coupon, and effectively unsecured by any of the physical assets of the bank, the credit instrument is based solely on the "full faith and credit worthiness of the bank". * Obviously the format of the credit instrument must be one which is acceptable in an jurisdiction and freely transferable, able to be settled at maturity in simple terms and is without restrictions other than its maturity conditions. The instrument which immediately comes to mind is the Documentary Letter of Credit or Standby Letter of Credit. * Standby Letters of Credit also serve as substitutes for the simple or first demand guarantee. In practice, the Standby Letter of Credit functions almost identically to the first demand guarantee. Under both, the beneficiary's claim is made payable on demand and without independent evidence of its validity. The two devices are both security devices issued in transactions not directly involving the sale of goods, and they create the same type of problems. [Extract from a paper entitled "Standby Letters of Credit: Does the Risk outweigh the Benefits?" published in the 1988 Columbia Business Law Review.] * The blank piece of bank paper which is technically as asset of the bank valued at say 2 cents is now "issued" and the text added in say "ten million U.S. Dollars face value", signed and sealed by the authorised bank officers. The question now is "what is the piece of paper worth?" Is it worth 2 cents or US$10 million, bearing in mind that it is completely unsecured by any tangible or real asset? In reality it has a "perceived value of US$10 million" in 366 days time, based upon the "full faith and credit of the bank". The next question which now must be asked is "will the bank honour its obligation when the bank note or credit is presented"? This will, of course, depend upon the reputation and credit worthiness of the issuer. * Having now arrived at the "belief" that the "value" is US$10 million in 366 days time, the "Buzer" must negotiate a price, or discount, which is acceptable to the Bank to cause it to "sell" the credit. * To arrive at a sale price one has to determine the accounting ramifications of the sale. The liability is US$10 million payable "next year", and it is important to note that the reason for the one year and one day period is to take the liability into the next financial year, no matter when the credit is issued. The liability is held "off balance" sheet and is technically a contingent liability as it is not based upon any asset. On the other side of the model, the bank is to receive cash from the "sale of an asset" and this cash is classified as capital assets which in turn are subject to the ratio multiplier of say 10 times. * So in real terms, the issuing bank is to receive say 80% of the face value upon sale which is US$8 million cash on hand against a forward liability of US$10 million in one year and one day's time. The actual contingent liability being US$2 million. The cash received, US$8 million allows the bank to lend 10 times this amount under the capital adequacy rules, so US$80 million is able to be lent on balance sheet against normal securities such as real estate, etc. If the interest rate is say 8% simple and the loans are short term, say one year, to coincide with the liability, the income and return (without taking into account the principle sums loaded) from interest alone is equal to US$6,400,00. * At the end of the year the credit is due for payment against the cash on hand and the interest received, in other words, US$8 million plus US$6,400,000 which total US$14,500,000 less the US$10 million shows a gross profit of US$4,400,000 or 44% plus the full value of the loan amounts (principle). * The reason for issuing the credit is now obvious, the resultant yield is well over the given discount and the bank is in a profitable position without risk. They have achieved a greater asset yield than by any conventional means. There is a greater underlying reason which is also indicated if an overview of the complete supply system is taken. To simplify the explanation, a flow chart h as been drawn which shows the roles of each entity and the details which are given by an individual who represented the information as direct from the "Federal Pool" which will be outlined herein. */ To understand the system one must take a view which is not supported by any physical evidence but is indicated by the actual occurrences of events. * As most people are not aware, the Federal reserve Bank is not a Federal Government entity or body, it is in fact a private institution. It may well operate in a quasi-government manner but it is still under the control of private individuals. * If one assumes that the money supply requirements for a specific period shows a need to print, say US$100 million of new issue currency, and the U.S. Treasury is required to issue same, the impact of the release of those "new" Dollars in terms of inflation and market effect is quite strong. * I, however, the U.S. Treasury through the Federal Reserve Bank was asked to forward "sell" those Dollars for "cash" the amount of "new" Dollars today is reduced by whatever amount is being yielded. If we take the case in question, suppose the Federal Reserve Bank had "contracted" with a major world bank to "issue" Dollar denominated one year paper in the amount of US$100 million and "sold" this paper through a secure network of entities so that the "sale" did not appear "on market" and that the "sale" was at a discount of say 80% of face value. The cash yield back to the U.S. Treasury would be US$80 million against a Dollar credit of same amount to the issuing bank, with the bank taking a US$100 million liability position at maturity date. * The U.S. Treasury has now received US$80 million in cash back in from the market/system and need only print US$20 million to meet its current obligation to the money supply. This is 20% of the original amount and, as such, its impact on the system is greatly reduced. Of course, if the amount "sold" is greater than the money supply requirement, the U.S. Treasury has a reduction which allows lower interest rates to be maintained and/or controlled. * The long term position is not affected as the bank has taken on the liability not the U.S. Government, the Dollar credit is classed as "cash" for the purpose of capital adequacy and is not required to be physically "printed" as such, a simple ledger entry is sufficient. The off market issue and sale of bank credit instruments is controlled by simple supply and demand techniques, and all U.S. Dollar denominated paper is "issued" through the Federal Reserve Bank. * To do this, the Federal Reserve Bank enters into an understanding with the U.S. Treasury and the top 100 world banks, excluding state operated banks, American Banks (with the exception of Morgan Guaranty), Third World banks and any other banks which may have a capital/credit problem. The current list (Based upon the January 1992 Bankers Almanac) totals some 62 banks. * Each bank agrees to allow the Federal Reserve Bank to issue, on its behalf, a specific amount of U.S. Dollar denominated paper or the alternative applies where the Federal Reserve Bank allocates a specific amount to each bank. The details are not published and no physical evidence has been made available to the author. In any case, the result is that a specific volume is available and the Federal Reserve Bank is now able to release it on demand. * The various bank paper is "pooled" together to give the total position for each year, and it is from the "Federal Pool" that the supply contracts are issued. The existence of the "Federal Pool" is not confirmed. However, various documents including GNMA transfer documents contain a "Pool Number". * The "collateral contracts" which one hears about, are effectively issued by the Federal Pool. It is indicated that these are usually issued in US$500 million units, with each minimum denomination being US$100 million. In other words, the minimum order is US$500 million in US$100 million tranches, it has been indicated that the "cost" or deposit for one of these contracts is US$100 million cash. This obviously reduces the number of entities who are able to participate. * One point which should be raised at this time, although the market place and issue of these instruments is "unregulated", the banks are effectively controlled by the B.I.S. and self imposed rules. Otherwise the whole system would be subject to possible manipulation and abuse by a bank, or group of banks, entering into a form of "insider trading", this would be detrimental to the system and the long term effect of same. * The entities who are the holders of the "collateral contracts" are commonly referred to as "cutting houses", as they usually reduce the side of the denomination from US$100 million to as little as US$10 million. They in fact "cut down the size of the note" hence "cutting house". * The cutting houses then in turn "sell" delivery commitments to wholesale brokers, the cost of such is indicated at approximately US$10.0 million cash. * In both cases the cash payment or deposit is able to be called upon if an order is not met or paid for on time, and if called for the contract holder would lose his contract and would be "blacklisted" in the system to prevent any new contract position. The rules are very simple, cash payment at all times for all notes ordered, this is a cash driven industry not credit. * It is assumed by the author that each cutting house would normally issue say 50 delivery commitments or "sub master commitments" at US$2.5 million each. Therefore, their deposit of US$100 million is now covered plus a reserve of US$25 million. This is very similar to the normal activities of pos betting where the odds are "laid off" to restrict exposure. * The wholesale brokers are responsible to feed the volume of instruments to the clients or customers who are at the retail or retail distribution level and, subsequently, to the secondary market. * The issuing banks can be identified as the manufacturers of this product, in this cast the product is bank paper. The Federal Reserve Bank can be identified as the importer (80%). The Federal Pool can be identified as the storage depot (82.5%) for all the product prior to sale and are responsible for the bulk release to the regional distributors. The cutting houses can be identified as the regional distributors (85%) and are responsible for the release of units to the local distributor. The wholesale brokers can be identified as the local wholesaler (87.5%) who release units on demand to the retail showrooms. The primary clients can be identified as the retail showroom (89%) who deliver the units to the public buyers. The public buyer exists in the secondary market (92 - 94%), such as pension funds, Middle East (Muslim) clients banks (to buy on the secondary market is not classed as contrary to the rule). They hold the instruments until maturity and gain the preferred yield from the discount against the face value (100%) from the issuing banks. The biggest problem encountered by the author regarding this matter is the contradictory and somewhat unusual attitude of the banks when any attempt is made to obtain any definitive documents or undertakings. The very existence of these instruments has been denied, at senior level by bank officials, and yet, within the same bank, requests to purchase said instruments have been received by the author. * Also the regulatory position of these instruments creates a major problem for any regulated entity to participate. How can an unregulated item be handled by a regulated body! * It is the opinion or the author, based on all the information available that the main reason for most of the mystery and misinformation is quite simple, this is a sophisticated form of financial engineering, it makes normal accounting principles a complete mockery and basically exposes the banking system for what it is. * In reality, the whole system is flawed and is one which no one really understands, we based our daily life on a "paper house". Nothing has really changed since the very first "money" transactions or even earlier, "I'll swap you two blue shells for three red shells and I'll give you three red shells for your XYZ goods". The whole monetary system is based on "perceived value" including currencies, credit, and day to day life. * A bank note issued by the Bank of England is in reality an unsecured "Promissory Note" payable and demand. Its face value is its perceived value, however, if the word demand were changed to a future date, of say one year and one day, the perceived value has now been reduced to cover the "cost of money" for the period. * If we were to discuss the value of one single £50.00 note, the "value" today would be approximately $45.00 However, if we wished to "discount the present value" several million of these notes, it is reasonable to expect that the "wholesale" buyer would expect a better "price". The note, however, still has a "perceived value" of £50.00 and a present value of approximately £45.00 Very little "cash" is used in the day to day operation of business, mostly it is in the form of ledger or "paper" entries. Even when a private bank account is used, most of all transactions are "paper" driven not cash. A cheque is a "Promissory Note", either unsecured or guaranteed by the bank up to a certain limit (cheque guarantee card). If a bank draft is "purchased" the draft is still unsecured but is perceived to be a 100% guarantee of payment. * The current trend towards "plastic" and "electronic banking" is an indication of the future and is based purely upon the amount of business which takes place daily. The banks can no longer cope with physical "paper" and need to reduce each transaction to a simple ledger entry. The end result is less "money" and more "business". * The use of these instruments as a medium for short term investment is obvious, if one takes the differential between the "invoice" price and the "present value" and moves a client into and out of the instruments on a regular basis, the effective yield is substantial. The downside risk is nil, if one retains strict protocol over the potential purchases, with a worse case scenario of the fact that a client would either NOT transact and therefore not be at risk. If an instrument had been purchased and for whatever reason could not be onwards "sold or discounted", the client would automatically achieve a substantial yield based on the maturity value against the "invoice paper". The preceding information is considered confidential and is not to be copied.