[photo caption/credit: Heavyweight Champ Joe Louis “You Can Run, But You Can’t Hide” (courtesy Google Images)]
Before declaring bankruptcy in 2008, Lehman Brothers was the fourth-largest investment bank in the US. It’s bankruptcy nearly toppled the US and global economies and helped precipitate the “Great Recession”.
When Lehman Brothers filed bankruptcy, its assets were only 3% greater than its liabilities.
Today, the Federal Reserve is the single largest central bank in the world. It’s assets reportedly exceed its liabilities by only 1.3%—less than half of what Lehman Brother had when if filed for bankruptcy in A.D. 2008. The Fed has much greater significance than Lehman Brothers and is operating with a much smaller “margin for error”.
The Fed’s potential for causing trouble for the US and global economies is enormous.
recently published an article with the peculiar title of “The global financial system is now resting on a margin of 1.3%.”
The article explained that,
“In 2008, the Federal Reserve’s entire balance sheet was just $924 billion. And the total of its reserves and capital amounted to $40 billion, roughly 4.3% of its total assets. Today the Fed’s balance sheet has ballooned to $4.5 trillion, nearly 5x as large. Yet its total capital has collapsed to just 1.3% of total assets.
“The Fed’s total capital corresponds to the Federal Reserve’s ‘net worth’. The value of the Fed’s assets needs to exceed their liabilities.”
That means that, on a percentage of assets basis, the Fed’s relative “net worth” has fallen by 70% in the past seven years. More importantly, insofar as the Fed’s assets now exceed the Fed’s liabilities by only 1.3%, that “net worth” is razor thin and there’s not much margin for error.
“In the Fed’s case, its liabilities are all the trillions of dollars in currency units that they’ve created, known as ‘Federal Reserve Notes’.”
I don’t necessarily agree that Federal Reserve Notes (FRNs) are the Fed’s liabilities because the Fed doesn’t redeem its FRNs. With real money, the government or bank that issued the paper currency is liable to “redeem” its paper dollars with something tangible like gold or silver. However, today, there’s no proviso for the Fed to “redeem” its FRNs with anything other than newer FRNs.
Insofar as FRNs are “redeemable” and therefore “liabilities,” they can be redeemed by the government as payment for taxes, but are mostly redeemed by the American people and peoples of the world who will trade their tangible wealth (homes, land, labor, commodities, food, resources, products, services, etc.) for FRNs. The government might redeem some FRNs as payment for taxes. The People might redeem FRNs as payment for their labor and private property. But the Federal Reserve does not redeem FRNs, so I don’t agree that FRNs are the Federal Reserve’s “liabilities”.
Even so, let’s proceed with argument presented by the Sovereign Man because it leads to a very interesting inference.
“The Fed’s assets are things like US government bonds.”
“Over the last several years during its multiple quantitative easing programs, the Fed has essentially created trillions of Federal Reserve Notes (i.e. ‘money’) and used those funds to buy US government bonds.
“In conjuring all that new money out of thin air, they created about $3.5 trillion worth of liabilities, which were offset by the $3.5 trillion worth of bonds they purchased.
“In total, the Fed’s “net worth” hardly budged.
“As a percentage of their total assets, their net worth really tanked [by 70%].”
As you’ll read, because:
1) the Fed’s “net worth” is only 1.3% of its total assets; and
2) most of the Fed’s assets are US bonds; then, it follows that,
3) the Federal Reserve is extremely vulnerable to changes in the values of its bonds.
If the market value of the US bonds held as assets by the Federal Reserve were to decline by, say, just 3%—that might be enough to overwhelm the Fed’s 1.3% positive “net worth” and thereby render the Federal Reserve technically insolvent.
“When Lehman Brothers went under in 2008, its total capital was 3% of its balance sheet. Today, the Fed’s 1.3% is less than half of that.”
The Lehman Brothers bankruptcy nearly collapsed the US and global economies. The Fed is far more important than Lehman was, but is running a much smaller “net worth”. More, the Fed’s net worth is extremely vulnerable to even a small decline in the value of its US bonds.
What might cause the value of US bonds to fall significantly?
The Sovereign Man explains:
“The universal law of bond markets is quite simple: bond prices and interest rates move inversely to one another. In other words, when interest rates go up, bond prices go down.”
Thus, if the current prime rate of 0.25% were raised even a little bit (say, to 0.50%), the market value of all US bonds would fall—including those held by the Federal Reserve.
“The Federal Reserve is sitting on $4.5 trillion worth of existing bonds, most of which they purchased when interest rates were basically zero.
“So what happens if the Fed raises interest rates? The market value of their entire bond portfolio will fall. Given the razor-thin capital the Fed has in reserve, they can only afford a tiny 1.3% loss on their bond portfolio before they become insolvent.
SovereignMan did not extend this argument further, but to me, the next inference is both obvious and crucial to understanding why the Fed has refused to raise interest rates for almost seven years.
We’ve seen the Fed do the dance of the seven veils for 80 months. Will they raise rates? Won’t they raise rates? Will they; won’t they? Is the economy strong enough to sustain a minuscule 0.25% interest rate increase—or is the economy still too weak?
Given that we’re only talking about raising interest rates by a quarter of a percentage point, the whole dilemma about whether the Fed will or won’t raise interest rates has seemed silly. On the face of it, we could suppose that a 0.25% increase in interest rates would be almost unnoticeable. If the economy is so weak that we can’t even raise interest rates by a negligible 0.25%, then the economy must truly be on life support and in need of last rights performed by an economic guru.
But, if we accept the SovereignMan’s argument that:
1) the Fed’s “net worth” is only 1.3% of its total assets;
2) most of the Fed’s assets are US bonds; and therefore,
3) the Fed is extremely vulnerable to changes in the values of its bonds—
Then, the Fed’s persistent refusal to raise interest rates makes perfect sense.
I.e., the Fed hasn’t raised the interest rate in nearly seven years because by doing so, they would reduce the market value of the $4.5 trillion in US bonds in the Fed’s portfolio.
Remember? The universal law of bonds? If interest rates rise, bond prices must fall?
That means that if the Fed raises interest rates from 0.25% to 0.50%, the market value of US bonds held by the Fed will fall. If that fall in bond market prices exceeded the Fed’s 1.3% “net worth,” the Fed would be technically insolvent and arguably bankrupt.
• God only knows what might happen if the Fed were perceived to be bankrupt. But whatever the results of a technical insolvency might be, they couldn’t be good for the US or global economies.
How much confidence could the world retain in FRNs as “world reserve currency” if the Federal Reserve were seen to be bankrupt?
If the Fed became insolvent because it raised interest rates, the value of the Fed’s fiat dollars would also have to fall significantly.
If a rise in interest rates caused the Fed to become technically insolvent, that wouldn’t necessarily collapse or kill the dollar. But it might not be surprising if the dollar’s purchasing power suddenly fell by 10%—20%—maybe more.
Further, once the Fed was shown to be insolvent, I think it would precipitate a spiraling crisis in confidence that would slowly feed on itself until—within a year or two—both the Federal Reserve and its FRNs were relegated to the ash heap of history.
In this context we can imagine why the Fed has persistently failed and refused to raise the Near Zero Interest Rate: doing so might destroy both the Federal Reserve and the fiat dollar. Since the Fed’s current 1.3% “net worth” is so small, any raise in interest rates—even by just another 0.25%—might be suicidal.
Therefore, not wishing to commit suicide, the Fed has logically and persistently refused to raise the interest rate for the last 55 Fed meetings over an 80 month period.
• For almost seven years, the Fed has justified its persistent maintenance of the Near Zero Interest Rate as being necessary to preserve and protect the US economy.
But, if the Sovereign Man’s argument is valid, the Fed’s justification is pure smoke. The Fed’s decision to hold the interest rated at 0.25% for nearly seven years is not about preserving the fragile US economy, per se. It’s about preserving the fragile Federal Reserve and the fragile FRN. If the Fed were to double the interest rate from 0.25% to 0.50%, and if the result was a loss of over 1.3% of the current perceived value of US bonds, the Fed might be destroyed.
Written by Alfred Adask
Full report at Adask’s Law
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