The Fed's Balance Sheet Leverage

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.

China Keeps Their Word: Sells Off US Treasuries

As advertised, China has decreased their holdings in US Treasury securities according to US government data. This decline actually started in April and ended a long trend by China of increasing US Treasury holdings. For more on this see the post below by Tim Iacono from The Mess That Greenspan Made.

Brad Setser over at the Council on Foreign Relations offers the following illustrative graphic along with three quick points about the April decline in treasury holdings by the Chinese:




While the net decline of some $4 billion is not all that significant in the scheme of things, there has been a dramatic change to the "second derivative" of their U.S. debt accumulation in recent months (a "rate-of-change" yardstick that has been increasingly popular lately), a development that is well worth noting.

This report in CHINADaily adds a few insights:

For the first time in 11 months China's holdings of US Treasury bonds fell - to $763.5 billion in April, US government data showed.

The figure, down from March's $767.9 billion, was the lowest since June 2008.

They do not include US Treasury bond holding in Hong Kong Special Administrative Region, which climbed to $80.9 billion in April from $78.9 billion the previous month.

The decline in the China holding "seems to stem from net selling of Treasury bills," said Chirag Mirani of Barclays Capital Research.

Now, those are not words that any U.S. policymaker wants to see appearing in the same sentence - "net selling of Treasury bill" and "China".

It's all about funding our huge deficits to perpetuate life as we've all come to know it...

As the largest holder of US Treasury bills, which are crucial to funding Washington's multi-trillion-dollar recovery plans, China had expressed concerns recently over what it called the safety of its dollar-linked assets.

US Treasury Secretary Timothy Geithner traveled to Beijing about two weeks ago to reassure Chinese leaders, saying their money is "very safe" despite the US budget deficit, which he pledged to cut.

There's been lots of intrigue in FOREX markets lately, with the BRIC countries (Brazil, Russia, India, and China) meeting today without the U.S. even in an observer role and recent comments from China citing concern about the greenback with a Japanese finance minister voicing strong support for the dollar.

Most puzzling are comments from Russia where they first sided with the Chinese, then showed support for the U.S. currency at last weekend's G8 meeting. Today, according to this AP report, Russian President Dmitry Medvedev said the world needs new reserve currencies.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

US Bonds: Not Worth The Risk

Despite the yield of the 10-year US Treasury bond rising to 3.76%, bonds are not worth the risk that the return will be canceled out by inflation. Martin Hutchinson argues that bonds are not a safe investment, and it's not because he thinks the US will default. To learn more see the following article from Money Morning.

With budget deficits on the rise and inflation almost certain to follow, it’s getting easier to see why British or U.S. government bonds are no longer a truly safe investment.

Standard and Poor’s Inc. (NYSE: MHP) last week put Britain’s credit rating under review for a possible downgrade, a precursor to a potential reduction in the country’s AAA credit rating. Since that indignity was avoided even in 1976, when Britain had to be bailed out by the International Monetary Fund (IMF), this raises questions about the safety of an investment in Britain’s government debt.

Needless to say, Britain and the United States have pursued similar policies in response to the ongoing global financial crisis, and are currently running similar budget deficits: Britain’s budget deficit this year will be 12.3% of gross domestic product (GDP), compared with 13.2% for the United States, according to The Economist.

Given those parallels, Britain’s credit review has to raise questions about whether a similar fate might await U.S. Treasuries. Indeed, the 10-year U.S. Treasury yield has already risen to 3.45% from its low of 2.07% in December, and it appears likely to rise even more.

That brings us back to my opening question: Should individual investors who are subject to inflation even consider U.S. Treasury bonds as a safe and secure investment?

Let me give you an extreme example - one that has jaundiced my entire view of government bonds since childhood. My Great Aunt Nan, a favorite relative in my childhood who had operated a small business, retired at 65 in 1947, having been born in 1882, one year too early for a self-employed person to qualify for a government pension in Britain. That was no problem, however - she had pretty substantial savings, which if invested prudently would give her enough income for a comfortable retirement. So she invested those savings prudently - and, indeed, patriotically - in a British government “War Loan” then yielding 2.5%, a “consol” paying income perpetually, with no maturity date. It gave her a retirement income of about 400 pounds a year, equivalent to about $30,000 today.

Actuarially, she was lucky - she lived in quite good physical and mental health to 91, which meant many happy visits to her during my childhood in the 1950s and 1960s.

Financially, she was rather less lucky, and suffered from an investment one-two punch:

• First, the War Loan in 1973 - the year of her death - yielded 10.8%, so the nominal value of her savings had declined by 77% (since the market value of a bond moves opposite the direction of interest rates).

• Second, consumer prices increased by 227% between 1947 and 1973, so the real value of her income had declined by 69%, and the real value of her savings had declined by 93%.

Government bonds - a safe investment. Yeah, right …

Obviously, there are examples that make the opposite case. For instance, if you had invested in long-term U.S. Treasuries in 1981, when they yielded around 15% (the U.S. prime rate actually reached 21.5% during that period), you would have done very well, indeed: The U.S. Federal Reserve, having finally vanquished inflation, embarked upon a rate-reduction campaign that brought American interest rates down at a steady rate for much of the rest of that decade.

But since governments control both monetary and fiscal policy - and since politicians are politicians - they combine to engineer things so that there are far more bad years than good years to be an investor in government bonds. Central banks and insurance companies buy government debt because they have to, but there’s no reason for you and I to get involved in these unattractive one-way bets. Even at 3.5%, 10-year U.S. Treasuries are a positively bad investment, since the U.S. budget deficit is so large that supply of them will never be limited, while inflation looks likely to reappear in force, draining the value of these bonds as inflation did to the savings of my great-aunt.

As daunting as all this all sounds, it’s not the worst that could happen: We still haven’t considered the possibility that the government could actually default on its debt.

Economists will tell you that governments can’t default on bonds in their own currency, because they can always print more money. In extreme cases, printing more money will lead to high inflation or even hyperinflation, leading to an effective repudiation like that perpetrated on my great aunt, or even like that carried out by the German Weimar Republic in 1923, when German prices were measured in the trillions of marks.

Economically, to avoid Weimar 1923, it would be better for a government to default outright, because at least non-government bonds and shares would still be worth something, and values would not be altogether destroyed.

After all, think about it - which would you expect to provide better investments: private companies, which create value, or the government, which merely spends money?

There are no sure things in life, but there are better investments and worse ones. Today, Brazilian government bonds, currently yielding 11.86% in Brazilian reals for an eight-year maturity, are a sounder investment than U.S. Treasuries; Brazilian inflation is expected to run 4.4% in 2009, so that’s a real yield of 7.46%, and the Brazilian budget deficit is only 2% of GDP.

Gold is always attractive while you think inflation is imminent - even at its current price, which is close to $1,000 an ounce. The gold market at $100 billion a year of production is far too small for the potential demand from central banks and speculators, so if inflation gets a real grip, the price of gold could easily go to $5,000.

Then there are stocks. Not cyclical stocks, which will suffer badly if the government finance chaos causes an even deeper recession than we already have. But shares in modestly leveraged companies producing low-priced consumer staples, which will continue to be purchased in even the deepest recession. In this area, think about such companies as The Procter & Gamble Co. (NYSE: PG), The Coca-Cola Co. (NYSE: KO), The Hershey Co. (NYSE: HSY) or, for lowish-priced entertainment, why not Nintendo Co. Ltd. (OTC ADR: NTDOY)?

In one way or another, Procter & Gamble, Coca-Cola, Hershey and Nintendo add value to our lives.

And to my way of thinking, that makes each of these a much better investment than a debt-ridden government. Don’t you agree?

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.