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Federal Reserve Notes Backed by Worthless Mortgage Bonds- Who Will Bail Out the Fed?

Interest-Rates / Credit Crisis 2008 Apr 18, 2008 - 05:20 PM GMT

By: Andy_Sutton


Best Financial Markets Analysis ArticleThe silence has been deafening. Since that fateful weekend in the middle of March when they almost lost control, things have been eerily quiet. In fact, today, the DOW finds itself up over 200 points in the face of another $5 Billion in losses at Citigroup. The losses have been spun as positive with most in the financial press saying in essence that we should be happy because it could have been a lot worse. Many have now even boldly called a bottom in the losses stemming from the subprime mortgage crisis. Haven't we heard this before?

In the Fed's defense, it has been extremely creative in using alphabet soup acronyms, fancy formulae, and dazzling doublespeak, all with the single purpose of placing money in the hands of those who have misbehaved without actually saying they're doing it. They have lent Treasuries and other assets off their balance sheet while accepting onto it a plethora of worthless mortgage bonds, credit derivatives, and other dubious instruments of the once gilded age of modern financial genius. And on the weekend of March 15-16, they became the final backstop: the lender of last resort.

We are learning firsthand the lesson that the longer a fraud is perpetuated, the more it must be perpetuated, because to allow it to collapse would be far too traumatic. The justification that Ben Bernanke used for getting involved in the Bear Stearns mess was that to sit on the sidelines would have meant a likely collapse of the financial system. That is how far things have gone. Perhaps we had quite a bit of warning though. Don't forget that it was 2 now defunct Bear Stearns hedge funds that fired the early warning flares of this mess.

There is one burning question that needs asking as a result of the steps the Fed has taken to ameliorate banking losses:

Is it not true that to an ever-increasing degree the Federal Reserve Notes that circulate in the economy are now ostensibly backed by worthless mortgage bonds rather than AAA rated US Government Treasury bonds?

While some might argue that from an intrinsic value standpoint there is essentially no difference between US Treasuries and junk mortgage bonds, I would opine otherwise, choosing to point out the possible perceptions of this transition. Much of the reason we have been able to borrow from foreigners all these years is that the Dollar, and the obligations of the United States have been backed by the full faith and credit of the US Government. I guess we need to change that. Should we come right out and say that the US Dollar and all of our obligations are now backed by worthless mortgage bonds? This is essentially what the Fed has done by accepting this junk onto its balance sheet.

The Fed has told us though that these loans are only temporary, in many cases as few as 28 days. Then the banks will have to give back the Treasuries they've been lent and re-assume the worthless bonds. Does this honestly make sense to anyone? How will these banks be able to repair billions of dollars in damage in a month's time? They won't. These loans, while starting as temporary will quickly become permanent. This will likely be done behind closed doors and out of the public eye with no announcement or fanfare.

It is fairly easy to see where things go from here. Even assuming a best-case scenario in which we have reached the bottom in credit losses, we have only seen about half of those losses. That means we are in the eye of the hurricane with billions more in losses to come before it is truly over. That means more Treasuries moving out of the Fed, and more worthless mortgage bonds going in. At some point, the Fed, absent hyperinflation, will simply run out of money and/or Treasuries. In either case, the next logical question to ask is:

Who will bail out the Fed?

In reality, we already know the answer to this. It lies in the record high gasoline prices, record high food prices, and either record or near-record prices in almost everything else. You and I will bail out the Fed. Not with money, but by a loss in our standard of living caused by the debasement of our money which is necessary to perpetuate the status quo and bail out a woefully ill financial sector.

Many months ago, I forecasted that we would see a brief period where deflationary forces would tug at our economy, and the powers that be would respond with massive infusions of liquidity. In my opinion, we have reached that inflection point. For a year we have seen credit destruction as loans have gone bad, resulting in massive losses. The response, while slow at first has been decisive as of late. M3 growth statistics collected by various interested parties support this thesis. The monetary base is growing at a record pace: over 17% y/y as of last week. That growth in turn will fuel consumer price inflation moving forward at an ever-accelerating rate regardless of what the irrelevant CPI states.

Despite many perceptions to the contrary, the events in the financial and banking system affect each and every one of us, regardless of whether or not we own stock, have a mortgage or carry a credit card balance. We all have one thing in common: we use the Dollar as our unit of exchange, and that alone means that we have been, are, and will continue to be affected by the ultimate bailout.

For ongoing discussion of this and other important topics, listen to ‘Beat the Street' our weekly Internet Radio Broadcast on Blog Talk Radio. For more information or to listen, visit

By Andy Sutton

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit

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