The Fed: Our Next Troubled Biggest Bank?

By: Money_and_Markets

Mike Larson writes: The Federal Reserve is watching the backs of U.S. banks. But sometimes I wonder, “Who’s watching the Fed’s back? Is the Fed our next troubled bank?”

You see, all of this garbage paper that’s going bad — the troubled residential mortgage backed securities (RMBS), the commercial mortgage backed securities (CMBS), the asset backed securities (ABS), the Fannie Mae bonds, the corporate loans, and so on — hasn’t just gone

You see, all of this garbage paper that’s going bad — the troubled residential mortgage backed securities (RMBS), the commercial mortgage backed securities (CMBS), the asset backed securities (ABS), the Fannie Mae bonds, the corporate loans, and so on — hasn’t just gone “Poof.”

Instead, more and more of it has been landing on the Fed’s doorstep — either through direct ownership or as collateral against Fed loans that keep getting rolled over.

The result? The Fed’s once pristine balance sheet is starting to look more and more like the balance sheet of a troubled financial institution.

From AAA to Something Else Entirely

What do I mean? Well, take a look at this April 26, 2007, Federal Reserve Statistical Release. Table 2, the Consolidated Statement of Condition of All Federal Reserve Banks, shows the breakdown of the Fed’s assets back then.

In 2007, 89 percent of the Fed’s assets were in risk-free Treasuries. Since then, that number has plummeted to a scary 24 percent.

You’ll see that the Fed banks listed total assets of $883.5 billion at the time. The lion’s share of those assets — $787.1 billion, or 89 percent — were “AAA” quality U.S. Treasury bills, notes, and bonds. There were a few other assorted line items (gold, bank premises, etc.) … but that’s about it.

Now compare that two-year old balance sheet, to this multi-headed hydra of a balance sheet that came out a few days ago. The equivalent table (number 9) shows that total Fed assets have exploded to $2.19 TRILLION. And those plain-vanilla, risk-free Treasuries? They make up just $526.1 billion, or 24 percent, of Fed assets!

The Fed now also owns more than $355 billion of mortgage backed securities and $61 billion in debt issued by Fannie Mae, Freddie Mac, and Ginnie Mae. Term auction credit comes to $455.8 billion. Those are short-term loans against just about anything and everything — from auto loans and credit card receivables to Brady Bonds and CMBS.

The Fed is also holding $238 billion in commercial paper as part of an October 2008 program to help corporations fund short-term debt obligations. And it has $111 billion in so-called “other loans.” This all-purpose category includes loans made to primary dealers ($12.9 billion), bailout baby AIG ($45.1 billion), and loans made as part of the Fed’s Term Asset-Backed Securities Loan Facility ($5.1 billion).

Finally, the Fed has lent money to so-called “Maiden Lane” LLCs that acquired dodgy asset portfolios as part of the Bear Stearns and AIG bailouts. The grand total there comes to $72 billion.

Bottom line:

• The quality of the balance sheet of the U.S. central bank is deteriorating.
• The Fed is now heavily burdened by the same kind of crappy paper that has been hammering private U.S. banks for several quarters.
• And the Fed banks are holding total capital of just $45.7 billion against the sum total of $2.19 trillion in assets, meaning the Fed is leveraging its capital 48-to-1. That compares to only 27-to-1 two years ago.

What’s the Risk?

With the Fed doing its best to tarnish its balance sheet and the Treasury borrowing like crazy (not to mention the Fed monetizing some of that debt), the natural question becomes: “What’s the risk?”

The answer is that it all comes down to the reaction of the capital markets …

• Do investors continue to aggressively bid on U.S. Treasuries at our debt auctions?
• Do foreign creditors, who hold more than 53 percent of the privately held Treasury debt outstanding, start balking at supporting our profligacy?
• Does the U.S.’s AAA credit rating come under closer scrutiny?
• And does the dollar start to reflect the fact that the Fed is throwing money around like a drunken sailor — and taking on any and all kinds of crummy assets?

These questions likely won’t be answered today, tomorrow, or next week. We may not learn for months or even quarters. But that doesn’t mean we shouldn’t discuss these risks now … that those risks aren’t very real … and that you don’t want to start taking some protective steps now.

Now might be the time to get rid of long-term U.S. bonds and buy some gold.

I warned about an impending blow up in residential real estate in 2005. If you sold housing, construction, and mortgage stocks back then, you dodged the worst meltdown in modern history. I warned that commercial real estate was in big trouble in early 2007. If you sold your REITs then, you dodged the biggest crack up in office, industrial, and retail real estate shares in ages.

Now, I recommend you consider buying some gold and dump the heck out of any long-term U.S. bonds. Because some day, the trashing of the Fed’s balance sheet is going to matter, and in a potentially huge way.

Until next time,

Mike

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