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November 10, 2008

What's Up, Doc?
by Bud Conrad

Under Bernanke's direction, the Federal Reserve has completely rewritten its mission. Many articles in the International Speculator and The Casey Report have reported the strange growth in the loans they have made and explained that Bernanke has, for a long time, espoused unconventional actions to avert deflation and to expand the economy. So the charts below tell that story, and it is truly amazing.

The Federal Reserve was never envisioned to be lender of last resort to a whole slew of investment banks, money market mutual funds, and commercial paper issuers.

The situation is not easy to sort out, for the simple reason that the extent of their actions is not presented by the Fed via clear and concise data. Instead, the data is complex and hard to analyze, partly because of the piecemeal way the actions were taken, but also probably due to a desire by the Fed to avoid public scrutiny and criticism.

Digging into the details of the Fed's balance sheet reveals, however, the complete change of composition and direction of the Fed. The most obvious change is that they have doubled the size of their assets and liabilities. A year ago, the Fed's assets consisted almost entirely of government Treasuries and a little gold.

That is a clean, safe balance sheet.

The only important liability was the currency they issued (our paper dollars). They also had a small reserve of deposits from all the banks. When Greenspan wanted to give the economy a boost by lowering short-term interest rates, he would create some money and buy Treasuries. He could also do the reverse.

Bernanke has turned this upside down. Initially he made focused loans to big banks. But then the loans became bigger than the reserve deposits, leaving the banks in total as net borrowers. The concept of a fractional reserve no longer applies when the reserve is net negative.

To fund yet more loans, Bernanke then sold off half of the Fed's Treasuries. And he traded Treasuries for toxic waste of poor-quality mortgage-backed securities. And he encumbered half of the remaining Treasuries with "off balance sheet" swaps of about $220 billion. (Does this sound like Enron accounting?) The balance sheet started with $800 billion of mostly reliable assets and now has about $250 billion of unencumbered Treasuries.

The biggest source of funding is from the Treasury. Banks are leaving deposits in the Fed now that the Fed is paying interest.

The important conclusion is that the paper dollars are now issued by a far less soundly structured Fed, an organization that is more interested in bailing out the financial community than defending the dollar.

This chart below compares last year's assets, which were mostly Treasuries, to this year's twice-as-large and far more questionable mix:

The other side of the balance sheet shows that the Fed has borrowed and taken in deposits to fund the loans that are as big as the issuance of currency. In effect, the Fed has doubled its footprint and doubled its responsibilities. Mostly under the covers, they added almost $1 trillion new credit to the financial world in about two months.

There are additional important Fed actions not included in their balance sheet. For example, they invented a Money Market Investor Funding Facility (MMIF) to guarantee up to 90% of $600 billion of loans to that sector. They do this through special-purpose vehicles established by the private sector (PSPVs). The latest Commercial Paper Funding Facility (CPFF) started October 27 and has issued $143 billion so far. These are both in addition to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility initiated September 19. The programs are beyond keeping up with.

Nothing like this has ever been done before by the Federal Reserve. In time, the consequences in terms of confidence in the dollar will be bad.

Bud Conrad is the chief economist of Casey Research, LLC., providing fiercely independent analysis and investment recommendations for subscribers in the U.S., Canada, and over 150 other countries around the world.

Powerful forces are at work in the economy; a global tidal wave of bank failures, credit crises, and sky-high debt. The central banks of the world may not be able to stave off what's coming -- but you can protect yourself and profit... by catching one of the massive market riptides Casey Research identifies every month in The Casey Report. Don't miss the lifeboat that can take you to financial safety. Learn more here.

Bud Conrad

Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Bud Conrad has been a futures investor for 25 years and a full-time investor for a decade.

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