In-depth analysis on Credit Writedowns Pro.

If the Fed were a commercial bank, it might be declared insolvent

Recently, I have written quite a few posts highlighting the U.S. Federal Reserve’s ballooning balance sheet. It has increased purchases of assets at an unprecedented clip. In fact, that balance sheet had $900 billion in assets just this past year. By year’s end, we should expect it to have risen more than three-fold to $3 trillion. This is a wild experiment without parallel in modern history.

But, there is a cost to all of this. One cost, hidden behind much of the chatter about bailouts, loans to lending institutions, and debt guarantees, is the damage to the Fed’s balance sheet. If the Federal Reserve were a commercial bank, any regulator would declare the institution insolvent due to inadequate capital and shut it down. The Federal Reserve now has leverage of over fifty times capital and this figure is expected to rise. The Fed needs $48 billion in capital just to get back to the capital ratios it had last year.

How this experiment ends is anybody’s guess. However, below is an article in this week’s Barron’s pointing out how extreme things at the Federal Reserve have become. Notice the sharp reduction in U.S. treasurys and the huge increase in securities lent to dealers and overall assets. Very worrying.

If the Federal Reserve were a commercial lender, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed’s current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits — to banks, brokers, money funds and foreign countries — that its balance sheet, viewed one way, is as leveraged as any hedge fund’s: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed’s role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren’t there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

“If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it,” says Ed Kane, a Boston College finance professor.

[fedtable]

Adds Walker Todd, a former Fed lawyer: “The Fed has stretched its authority farther and wider than it ever has in its entire history. The risk is that they won’t be able or willing to mop up all this excess liquidity when it comes time to head off inflation a few years down the road.”

How did the U.S. central bank, under Ben Bernanke, get to this place? The boldest move hit the headlines on St. Patrick’s Day, when the Fed made its unique 10-year loan to bail out Bear Stearns by backstopping JPMorgan Chase’s (JPM) purchase. That was done, some say, to prevent the domino effect that Bear Stearns’ collapse might have had on certain big counterparties, including banks.

In September, the Fed provided $85 billion to American International Group (AIG), effectively taking control of the world’s biggest insurer in a deal that’s since been restructured. And the central bank has poured so many billions into the commercial-paper and money-market mutual-fund markets that one in every seven dollars, about 15% of the $1.6 trillion commercial-paper market, is Fed-supported.

The Fed also created special lines for London offices of primary U.S. government dealers after the Bank of England cut off its short-term lending to them because Lehman Brothers repatriated $8 billion to New York from London just before its bankruptcy filing.

Then came the $571 billion in foreign-currency swap lines funded and operated by the Fed. The last time swap lines were used in a major crisis, the so-called Exchange Stabilization Fund — to bail out Mexico in 1995 — was operated by the Treasury and Fed.

The Fed has its supporters. “Given the alternative — doing nothing in the face of a crisis — the Fed has done a remarkable job of holding the system together by inventive use of short-term liquidity,” says Charles Blood, senior strategist at Brown Brothers Harriman.

Yet others see a willy-nilly series of moves that didn’t weed out insolvent banks. Boston College’s Kane blames Treasury Secretary Henry Paulson for frightening Congress into parting with $700 billion. Kane’s view is that the Fed’s independence has been compromised by working too closely with Treasury.

For all that, banks remain reluctant lenders, because no one’s sure who’s solvent. Reserve balances held with Federal banks now rest at $592 billion, up from the normal $15 billion in the months prior to September.

“The Fed has violated two principal tenets of central banking,” says Lee Hoskins, former president of the Cleveland Fed: “First, don’t lend to insolvent institutions, and second, don’t lend on anything but the most pristine collateral” — and at a penalty rate.

In lending and selling off most of its hoard of U.S. Treasuries, the central bank may not have the resources to sop up all the liquidity. Its current accounts show that the Fed’s holdings of Treasuries not already lent to dealers have dropped to about $250 billion, the lowest level since the late 1980s.

The Fed needs at least $48 billion more in capital to return to 2007 levels, just to meet the standard it demands of banks, says Gerald P. O’Driscoll, a senior fellow at the Cato Institute and former vice president of the Federal Reserve Bank of Dallas. And some of that capital might go into reserves to shield against unanticipated loan losses. “[The Fed has] spooked the market with [its] scare tactics and ever-changing plans,” he says “The Fed’s actions coupled with the Treasury’s bailout of the banks have taken us one big step closer to corporatism — big business in cahoots with big government.”

It’s possible some of the better-capitalized regional Fed banks may balk at some point. “Of course, there are plenty of regional Reserve bank presidents and directors deeply concerned about what the Fed has done,” says Hoskins. “But how do we register that concern?”

Source
Has the Fed Mortgaged Its Own Future? – Jack Willoughby, Barron’s

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

9 Comments

  1. Alex says:

    I guess we can only hope that the Fed and Treasury are smart enough to profit from their investments. Just as the government saw a $660 million profit from its bailout of Chrysler in the seventies, the warrants and preferred stock that is part of the bailouts may be worth something in the not-so-distant future. There seems to be a risk-reward expectation that is allowing the wild speculation and out of kilter capital ratios to go unchecked. There has been a good on-going commentary on the bailouts at: http://www.thebailoutblog.com

  2. Stevie b. says:

    “The risk is that they won’t be able or willing to mop up all this excess liquidity when it comes time to head off inflation a few years down the road.”

    Whilst I don’t understand this $48 billion shortage-of-capital business (surely a drop in the ocean. Someone somewhere – the Treasury, the Chinese? – can just give ‘em the money or something, can’t they…?!), the end game from the above quote is the 64,000 dollar (how quaint that now seems!) question.

    For me, there are some really interesting comments from Rebecca Wilder that have helped my understanding of this inflation/deflation/quantitative easing issue: http://www.newsneconomics.com/2008/11/monetization-sterilization-whats-going.html

    Also comments from Stephen Jen yesterday at
    http://www.morganstanley.com/views/gef/index.html#anchor7238

    where he says amongst a lot of other things:
    “Our guess is that, while dealing with a liquidity trap is difficult, removing stimulus when macro conditions normalise should not be a major problem for the Fed. ”

    I am a bit amazed by this as no reason is given why removal shouldn’t be a problem, apparently regardless of the type/size of stimulus or rate of any eventual pick-up in velocity. Any thoughts Ed?

  3. Stevie, those are two very good articles and I will link out to them in a future post. The Stephen Jen analysis is certainly right on regarding the unwillingness of banks to lend and a reduction in the money multiplier. This is one reason that easing will have significantly fewer stimulative effects than in 2001.

    But, your question has to do with why Jen thinks removing QE will be easy. I will have to look at the article he referenced from Minneapolis Fed Chairman Stern and see what is in there. I sense you are skeptical. I am as well. If the Fed restarts the economy through massive quantitative easing, they will need to buy all that money back up by selling treasuries before inflation gets embedded in the system. We saw this past year with commodity prices how quickly inflation can become a problem. Given the massive amount of liquidity they have unleashed, it is reasonable to think inflation could take off if they reflate the economy.

    As for the shortage of capital at the Fed, the crux of it is that the Fed has ballooned their balance sheet without a commensurate increase in their underlying capital base. And given they have much riskier assets on their balance sheet, this makes more capital all the more necessary. To get back to the 1997 capital to asset ratios, the Fed would need an additional $48 billion in capital. This demonstrates how many assets they have bought.

    I will let you know what I find out about the Minnesota Fed Chairman’s comments and see if this helps us understand Jen any more.

  4. One crucial difference between the Fed and any commercial bank is that the Fed can create its own capital by simply printing money. Of course, this debases the value of its existing assets, but via inflation it also monetizes away some liabilities. Viola! Capital inadequacy solved with a devalued currrency. BTW, there won’t be any mopping up of inflation. Inflation is the Fed’s proposed solution.

  5. anthony, you are right on the money. If we could all create our own money, we would be able to inflate our way out of debt. As yo indicate this is what the Fed certainly plans to do as it has few other options available. The question is whether they will be successful in getting banks to lend because right now the money multiplier is contracting and the flood of money is increasing the monetary base, but just leading to a spike in excess reserves.

    I do not think they will be successful. However, if they are, consumer price inflation will certainly be an issue.

  6. John Creighton says:

    I’m not sure why selling treasuries are the best way to mop up extra liquidity in an inflationary situation. Sure they temporary take money out of the system but it has to be paid back at a later date. Their also highly liquid and can be sold on the secondary markets. If you truely wanted to take money out of the system to combat inflation wouldn’t you want to sell a physical asset like gold or property?

    • John, treasuries are considered the ‘risk-free asset and are the lowest yielding, highest liquidity financial asset the Fed owns. Traditionally, treasuries were the majority of the Fed’s asset base. So, when it came time to withdraw liquidity they would sell treasuries as they had plenty of them.

      See my post on the Fed’s Balance Sheet to see what I mean.

      Ostensibly, the Fed could soon sell the dodgy assets they are now about to buy in order to reduce liquidity. In a short period of time, they should have lots of these assets to sell.

  7. John Creighton says:

    I´m looking at the federal reserve balance sheet now.
    http://www.federalreserve.gov/releases/h41/Curren

    If I subtract assets from liability I get: 45,304 million dollars. Which is roughly what is in the above table. As for the capital requirements. Remember that banks are only required to capitalize against their risk based assets under biss.
    http://wfhummel.cnchost.com/capitalrequirements.h

    Since most of the feds capital is government securities (e.g. treasuries) which is considered to be zero risk they are not required to capitalize against it under BIS.