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Which Bank Is Leveraged 104:1?

Posted by Larry Doyle on July 14, 2011 9:02 AM |

The road to hell is paved with positive carry.

Those in financial circles likely know that the above quote is a colloquialism used to highlight that excessive leverage can generate cash flow, that is the positive carry, but that ultimately unless properly and prudently unwound the leverage itself can lead to financial armageddon. We have witnessed this scenario time and again.

Wall Street specifically and our economy at large are continuing to lick their wounds and attempting to recapitalize from the “road to hell” we experienced beginning in 2008. While the financial system as a whole deleverages, Ben Bernanke and his minions within the Federal Reserve have leveraged up in an attempt to ‘ease the pain’. Just yesterday, Fed officials highlighted that they would continue to leverage up if need be.

In the process, I believe they will simply be moving further down that road to you know where

Just how much has the Fed leveraged up? Let’s navigate.

Thanks to a regular reader for sharing a story recently released by Forbes which inquires, Could a Federal Reserve Bank Go Bust?,

Citigroup and Bank of America are not permitted to use such accounting. Market losses on tradable securities hit their balance sheets. The discipline forces commercial banks to do a pretty good job of matching assets and liabilities in interest rate sensitivity. The Fed has no such discipline.

So far this year interest rates have trended down, not up, and the Fed’s profits are robust.  Where do the profits go? A $1.6 billion sliver goes to commercial banks as dividends on their shares of stock in the 12 Fed banks. Most of the Fed’s net income goes back to the U.S. Treasury as a fee for the right to issue banknotes.

Like commercial enterprises, the Federal Reserve banks have an equity cushion to cover losses. But not much of one. The system has a Lehman Brothers-style leverage of 55 to 1. At the New York bank, the one that Timothy Geithner used to run, leverage is 104-to-1.

104:1!! YIKES!! Yes, the Federal Reserve Bank of New York is carrying $104 of assets for every $1 of equity capital. Does that sound like a house of cards to you? You think??!!

We all know that Ben Bernanke and his sidekick Timmy-boy remain the dealers extraordinaire in the shell game that masquerades as our capital markets but what happens if and when Ben and Timmy lose control.

Why do Ben and Tim quake and quiver while the debate on the raising the debt ceiling continues? For the very simple reason that raising the debt ceiling is a necessary function which allows the shell game to continue and is needed to allow the Fed to unwind this leverage. Hopefully!!

Make no mistake, though, the shell game and the road to hell are fraught with very real risks. How so?

Until the Great Recession, the Fed limited its purchases of Treasury paper to short-term bills that carry no interest rate risk. The 2008 financial crisis changed that.

The Fed banks began buying risky assets on a large scale: longer-dated Treasury paper and mortgage securities. There’s little credit risk here (the U.S. Treasury stands behind most of the paper), but there is rate risk. When interest rates rise, bond prices go down.

Not to worry, insists Glenn Rudebusch, an economist at the San Francisco Federal Reserve Bank. In a paper published in April he notes that those bonds and mortgage securities are worth more than their purchase prices. The Fed, he proudly recounts, is still gloriously profitable.

Perhaps the Fed is profitable on paper, BUT what if the Fed had to sell their holdings? What if the market value of the Fed’s holdings plummeted and creditors were less willing to provide financing for all those borrowed funds which the Fed needs given its leverage?

But what if inflation shoots up? To restrain it, Bernanke would have to crimp the money supply. To do that he would have to sell some of those securities he’s been buying.

The hitch is that higher inflation means higher interest rates, and higher rates mean falling prices on the Fannie Maes and Treasury bonds. Sales at a loss would eat into the equity capital. To patch up the hole in its balance sheet the Fed would have to beg Congress or the U.S. Treasury for a bailout.

Ron Paul’s worst nightmare.

In this scenario there is no bankruptcy of the sort that has the sheriff carting off the furniture. There would merely be loss of face for the august institution Bernanke runs and a consequent loss of confidence in the dollar.

Says the Shadow Financial Regulatory Committee in a statement critiquing Bernanke’s quantitative easing: “Fed insolvency is not necessarily a low-probability event, and therefore, its consequences for monetary policy and reputation of the Fed are potentially important and worthy of consideration.”

It’s a polite way of saying that there could be a run on the bank. Federal Reserve notes are trust-me money. Do you trust the Fed?

Do you? Why do you think the shiny yellow stuff is regularly making new highs? A lack of trust.

Navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.

 

  • fred

    LD,

    I’d like to draw on your mtg securities market expertise.

    Is the mtg securities market functioning? If yes, what % of par (on ave), are securities trading at?

    Financials, and the Fed, are carrying these securities on their books at par, (thus assuming no delinquencies or foreclosures and hoarding cash), to cover the risk of default.

    Why doesn’t Private Equity get involved, is it the big elephant in the room?

    Banks need to be greasing the money multiplier by making business loans, let’s start the writedowns by beginning the process of selling these securities into the market (and not to the Fed).

    • LD

      Fred,

      The agency mortgage market (GNMA,FNMA, Freddie Mac securities) is deep and functioning very well. The non-agency market is much less vibrant with very little new issuance.

      The agency mortgage securities guarantee the timely or ultimate payment of principal and interest. The credit losses which have occurred and continue to accrue in these securities are assumed either by the FHA (GNMA) or by the GSEs (Fannie and Freddie). These losses for the GSEs specifically are ultimately and continually being absorbed by the Treasury, although in the case of the GSEs this occurs off Uncle Sam’s balance sheet. (Thus it is being disguised..)

      In the non-agency and sub-prime market the Fed still holds billions via Maiden Lane. The Fd took the pressure off the market and bought time for these market sectors to recover which they did but they have given back a fair bit of ground over the last few months as it became obvious that the housing market is still under real pressure.

      In the midst of this recent retreat the Fed has pulled back from selling bonds in order to take pressure off the market.

      The Fed has been the marginal buyer both in the Treasury market and mortgage market to keep the game going and rates in check. This morning’s commentary addresses the risks of this Fed policy and program.

  • wsm

    I think the following link cogently explains why the Forbes notion of comparing the Fed to commercial enterprises is preposterous.

    Treasury Style Go Around Not Over the Debt Ceiling Limit






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