If the Fed were a commercial bank, it might be declared insolvent

Recently, I have written quite a few posts highlighting the U.S. Federal Reserve’s ballooning balance sheet. It has increased purchases of assets at an unprecedented clip. In fact, that balance sheet had $900 billion in assets just this past year. By year’s end, we should expect it to have risen more than three-fold to $3 trillion. This is a wild experiment without parallel in modern history.

But, there is a cost to all of this. One cost, hidden behind much of the chatter about bailouts, loans to lending institutions, and debt guarantees, is the damage to the Fed’s balance sheet. If the Federal Reserve were a commercial bank, any regulator would declare the institution insolvent due to inadequate capital and shut it down. The Federal Reserve now has leverage of over fifty times capital and this figure is expected to rise. The Fed needs $48 billion in capital just to get back to the capital ratios it had last year.

How this experiment ends is anybody’s guess. However, below is an article in this week’s Barron’s pointing out how extreme things at the Federal Reserve have become. Notice the sharp reduction in U.S. treasurys and the huge increase in securities lent to dealers and overall assets. Very worrying.

If the Federal Reserve were a commercial lender, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed’s current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits — to banks, brokers, money funds and foreign countries — that its balance sheet, viewed one way, is as leveraged as any hedge fund’s: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed’s role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren’t there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

“If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it,” says Ed Kane, a Boston College finance professor.

Adds Walker Todd, a former Fed lawyer: “The Fed has stretched its authority farther and wider than it ever has in its entire history. The risk is that they won’t be able or willing to mop up all this excess liquidity when it comes time to head off inflation a few years down the road.”

How did the U.S. central bank, under Ben Bernanke, get to this place? The boldest move hit the headlines on St. Patrick’s Day, when the Fed made its unique 10-year loan to bail out Bear Stearns by backstopping JPMorgan Chase’s (JPM) purchase. That was done, some say, to prevent the domino effect that Bear Stearns’ collapse might have had on certain big counterparties, including banks.

In September, the Fed provided $85 billion to American International Group (AIG), effectively taking control of the world’s biggest insurer in a deal that’s since been restructured. And the central bank has poured so many billions into the commercial-paper and money-market mutual-fund markets that one in every seven dollars, about 15% of the $1.6 trillion commercial-paper market, is Fed-supported.

The Fed also created special lines for London offices of primary U.S. government dealers after the Bank of England cut off its short-term lending to them because Lehman Brothers repatriated $8 billion to New York from London just before its bankruptcy filing.

Then came the $571 billion in foreign-currency swap lines funded and operated by the Fed. The last time swap lines were used in a major crisis, the so-called Exchange Stabilization Fund — to bail out Mexico in 1995 — was operated by the Treasury and Fed.

The Fed has its supporters. “Given the alternative — doing nothing in the face of a crisis — the Fed has done a remarkable job of holding the system together by inventive use of short-term liquidity,” says Charles Blood, senior strategist at Brown Brothers Harriman.

Yet others see a willy-nilly series of moves that didn’t weed out insolvent banks. Boston College’s Kane blames Treasury Secretary Henry Paulson for frightening Congress into parting with $700 billion. Kane’s view is that the Fed’s independence has been compromised by working too closely with Treasury.

For all that, banks remain reluctant lenders, because no one’s sure who’s solvent. Reserve balances held with Federal banks now rest at $592 billion, up from the normal $15 billion in the months prior to September.

“The Fed has violated two principal tenets of central banking,” says Lee Hoskins, former president of the Cleveland Fed: “First, don’t lend to insolvent institutions, and second, don’t lend on anything but the most pristine collateral” — and at a penalty rate.

In lending and selling off most of its hoard of U.S. Treasuries, the central bank may not have the resources to sop up all the liquidity. Its current accounts show that the Fed’s holdings of Treasuries not already lent to dealers have dropped to about $250 billion, the lowest level since the late 1980s.

The Fed needs at least $48 billion more in capital to return to 2007 levels, just to meet the standard it demands of banks, says Gerald P. O’Driscoll, a senior fellow at the Cato Institute and former vice president of the Federal Reserve Bank of Dallas. And some of that capital might go into reserves to shield against unanticipated loan losses. “[The Fed has] spooked the market with [its] scare tactics and ever-changing plans,” he says “The Fed’s actions coupled with the Treasury’s bailout of the banks have taken us one big step closer to corporatism — big business in cahoots with big government.”

It’s possible some of the better-capitalized regional Fed banks may balk at some point. “Of course, there are plenty of regional Reserve bank presidents and directors deeply concerned about what the Fed has done,” says Hoskins. “But how do we register that concern?”

Source
Has the Fed Mortgaged Its Own Future? – Jack Willoughby, Barron’s