Sunday, January 16, 2011

Sunday Thoughts

A topic that seems to be coming up more and more often in the financial media is the concern over the solvency of the Federal Reserve, or if it is possible for them to go bankrupt.

The Fed is a privately owned bank, similar to a J.P. Morgan or Goldman Sacs, that has a special relationship with the federal government in that they are in charge of the money supply and interest rates.

The Fed, like every bank, has a balance sheet.  In normal times, the Federal Reserve will create money by purchasing treasury bonds from either the government or other banks.

When the Fed buys bonds from a bank, they give them cash in exchange.  This allows the banks to have more "reserves" in their bank vaults. (It is all done electronically)  With $10 in new reserves, the bank can then lend out $100 in new loans such as mortgages, credit cards, car loans, etc.

This is how the money supply grows.  When the Fed wishes to reduce the money supply, they will give the banks back the treasury bonds and ask for cash in return.  This reduces the "reserves" on hand for banks and forces them to tighten lending.

This is how the Federal reserve controls interest rates.  They "target" rates using this process. 

But what about the Federal Reserve itself? 

Remember the value of a bond, whether it is a government treasury bond or a mortgage for a home, goes up in down in value based on interest rates. (Most investors don't understand this which is why they are rushing into bonds at the peak of a bubble)

Let's say that the Federal Reserve purchases $1 trillion in mortgages. (They purchased $1.3 trillion last year) 

Let's assume that all the mortgages are 30 year bonds and they all have 30 years remaining on the loan.  The interest rate for each of the bonds is at 5%.

If the interest rates were to rise next year to 10% (interest rates would already be there today if the Fed was not buying bonds) then the value of the bonds would be cut in half, from $1 trillion to $500 billion.

The Federal Reserve, like most banks must keep cash "reserves" in the (electronic) vault to protect themselves from losses. 

If the Fed only had $100 billion in reserves, and they were forced to take write downs or show losses of $500 billion on their mortgage bonds, their balance sheet would show a negative $400 billion.  Meaning they would have to declare bankruptcy.

What would happen at that point is only speculation because we've never seen it before.  The Fed would have to go to Congress and ask them for a bail out.  (Congress could lend them $400 billion and add it to our national deficit, and the Fed could then print more money to purchase the bonds)

Kind of strange to think about isn't it?

What makes this unlikely to happen is that the Federal reserve does not have to follow traditional accounting standards.  If the bonds on their balance sheet were to be cut in half, the Federal Reserve through accounting gimmicks can still show these bonds at full value. 

The Fed says they can hold the bonds for a full 30 years, so the interest rates do not matter.  But what happens if homeowners stop making the 5% interest payments and then default on the loans?

That is where it would get even more tricky.

What most inflationists and deflationists who study this concept in detail don't take into account is that the Federal Reserve and Congress can just change the rules. 

We live in a world of "fiat" money which is backed by nothing.  In a monetary world with no rules, the likelihood of thinking about a Federal Reserve default is a waste of time.

Investors should focus on what happens if the Fed does not default and every asset in the world has the potential to be purchased with printed money.  The riots taking place around the world as food prices skyrocket is only a taste of what is to come.

And someday, maybe soon, the inflation being created today is going to wash back onto the shores of our own country creating a shock wave in the prices of food and energy that we use every day.

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