The Federal Reserve's balance sheet is leveraged 50-to-1 against it's capital, which is a greater leverage ratio than Fannie Mae or Bear Stearns. The Fed made an accounting change several weeks ago that will allow any losses to be reported as a new line item. Read more about this in the full post by The Mess That Greenspan Made.
John Hussman’s weekly commentary had this little item in it the other day about how the Federal Reserve’s balance sheet would look if it were viewed as something other than the assets and liabilities of the central bank of the world’s only superpower, with all the attendant rights and “make-it-up-as-you-go” privileges.
As a side note, it’s probably worth noting that the Federal Reserve has already pushed its balance sheet to a point where it is leveraged 50-to-1 against its capital ($2.65 trillion / $52.6 billion in capital as reported the Fed’s consolidated balance sheet ). This is a greater leverage ratio than Bear Stearns or Fannie Mae, with similar interest rate risk but less default risk. The Fed holds roughly $1.3 trillion in Treasury debt, $937 billion in mortgage securities by Fannie and Freddie, $132 billion of direct obligations of Fannie, Freddie and the FHLB, and nearly $80 billion in TIPS and T-bills. The maturity distribution of these assets works out to an average duration of about 6 years, which implies that the Fed would lose roughly 6% in value for every 100 basis points higher in long-term interest rates. Given that the Fed only holds 2% in capital against these assets, a 35-basis point increase in long-term yields would effectively wipe out the Fed’s capital.
To avoid the potentially untidy embarrassment of being insolvent on paper, the Fed quietly made an accounting change several weeks ago that will allow any losses to be reported as a new line item – a “negative liability” to the Treasury – rather than being deducted from its capital. Now, technically, a negative liability to the Treasury would mean that the Treasury owes the Fed money, which would be, well, a fraudulent claim, and certainly not a budget item approved by Congress, but we’ve established in recent quarters that nobody cares about misleading balance sheets, Constitutional prerogative, or the rule of law as long as speculators can get a rally going, so I’ll leave it at that.
Yes, it’s tough being a bear after a 2+ year long stock market rally and being reminded from time to time that, when Fed Chief Ben Bernanke puts his head on the pillow at night, he probably giggles to himself every once in a while, “I am the invisible hand” (hat tip DC).
This post was republished with permission from The Mess That Greenspan Made.