Insolvent Thinking

By: Fred Sheehan | Tue, Nov 12, 2013
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It is possible neither Janet Yellen nor another pretender will fill Bernanke's shoes in January. The odds of such a surprise may be once-in-a-history-of-the-universe, but those keep coming at a faster rate the longer we splurge. Simple Ben has been walking both his bank and the world's financial institutions closer to the cliff. Here, we will look at the precarious position of the Federal Reserve and the far-out financial securities entering the pipeline at an increasing rate.

The machinery of state demands exponential buying by banks, insurance companies, and pension funds. The purchasers risk insolvency by doing so. Chairman Bernanke would be the last to recognize this problem, unaware as he remains of his own institution's balance-sheet woes, and not understanding the financial calamity in 2007.

Central banking insolvency does not matter at the moment. The Emperor's New Clothes is preferred by Wall Street and the media alike.

The Federal Reserve's balance sheet is a mystery, but not that much of a mystery. John Hussman wrote in his November 4, 2013, letter to clients in ("Leash the Dogma"): "A brief update on the bloated condition of the Federal Reserve's balance sheet. At present, the Fed holds $3.84 trillion in assets, with capital of just $54.86 billion, putting the Fed at 70-to-1 leverage against its stated capital. Given the relatively long maturity of Fed asset holdings, even a 20 basis point increase in interest rates effectively wipes out the Fed's capital. With the present 10-year Treasury yield already above the weighted average yield at which the Fed established its holdings, this is not a negligible consideration."

The 10-year yield has risen from 1.40% on July 27, 2012, to 2.6% or so today. Thus, the Fed is insolvent six times over. Life goes on.

There have been no sightings of central bankers jumping from windows yet. Of course, it's not their money; it isn't money at all, so we pretend. Since the Fed governors are academics, their financial knowledge is wanting. A practical reason for reducing quantitative easing (q.e.); actually, a practical reason for never getting started; is the reduction in top-rung collateral. Banks and other financial outfits borrow and lend in the trillions every day. Treasury securities that have disappeared onto the Fed's balance sheet are no longer available for collateral.

The Fed can lower standards of collateral. It has in the past, but it cannot make a bank accept Bit Coin receivables. This was central to the insolvency of Bear Stearns and onward in 2008. J.P. Morgan and Goldman Sachs were not going to repo (lend overnight) with an institution that might be shut the next morning.

This sinkhole of miscalculations was up for discussion on October 18, 2008, when the Wall Street Journal published an interview with Anna Schwartz. The article opened: "On Aug. 9, 2007, central banks around the world first intervened to stanch what has become a massive credit crunch. Since then [note: over one year later - FJS], the Federal Reserve and the Treasury have taken a series of increasingly drastic emergency actions to get lending flowing again. The central bank has lent out hundreds of billions of dollars, accepted collateral that in the past it would never have touched, and opened direct lending to institutions that have never had that privilege. [The Fed will do anything, so watch your wallet. - FJS] The Treasury has deployed billions more. And yet, 'Nothing,' Anna Schwartz says, 'seems to have quieted the fears of either the investors in the securities markets or the lenders and would-be borrowers in the credit market.'"

Anna Schwartz was co-author with Milton Freidman of A Monetary History of the United States, 1867-1960. She went on to tell the Journal: "[T]he Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is [uncertainty] that the balance sheets of financial firms are credible." This was true although Simple Ben and aligned interests still refer to the "liquidity crisis," not the "insolvencies" in 2007 and 2008. The title of the Journal's interview was "Bernanke is Fighting the Last War."

And now, Fed Chairman Bernanke has led the Fed itself into insolvency. You can be sure there have been high level meetings at the largest financial institutions, pondering what to do if a fellow Too-Big-to-Fail Bank steps away from repo loans between itself and the Fed.

The Fed has introduced a slew of other problems attributable to its q.e. and to ZIRP (Zero-Interest Rate Policy). U.S. money-market funds break even by purchasing lower-rated European bank debt. Reuters, on September 25, 2013, reported: "Life insurance is becoming an unviable business in Europe as low interest rates reduce insurers' profits, forcing many to compensate with higher-risk investments or move overseas, according to an industry survey." A Bloomberg headline from September 26, 2013: "Pension Funds Need to Buy Higher-Yielding Assets, Allianz Unit Says." Also from Reuters: "U.K. Pension Funds Take on Leveraged Loans in Search of Yield."

The longer investors find themselves buying while holding their noses, the worse are the securities offered. Corruption is one result. The Financial Times reported on November 10, 2010: "[T]he credit rating agencies are using 'deluded' processes to calculate the risks of asset-backed securities (ABS).... 'Here is a situation where you keep putting more untenable risks into the system,'" declared William Harrington, who "spearheaded analysis on derivatives between 1999 and 2010 at Moody's Investors Services."

"However," the Financial Times goes on, "institutional investors such as pension funds and insurers have begun to increase their exposure to ABS once again, as low interest rates force them to search for alternative sources for yield."

 


Frederick Sheehan writes a blog at www.aucontrarian.com

 


 

Fred Sheehan

Author: Fred Sheehan

Frederick J. Sheehan Jr.
aucontrarian.com

Frederick J. Sheehan

Frederick J. Sheehan Jr. is an investor, investment advisor, writer, and public speaker. He is currently working on a book about Ben Bernanke.

He is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and co-author, with William A. Fleckenstein, of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve (McGraw-Hill, 2008). He writes regularly for Marc Faber's "The Gloom, Boom & Doom Report."

Sheehan serves as an advisor to investment firms and endowments. He is the former Director of Asset Allocation Services at John Hancock Financial Services where he set investment policy and asset allocation for institutional pension plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S. Naval Academy. He is a Chartered Financial Analyst.

Copyright © 2007-2014 Frederick J. Sheehan Jr.

 

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