Friday, November 5, 2010

Fed may go bankrupt

Right now the Fed’s balance sheet shows about $57 billion in total capital. Current assets are about $2.3 trillion. The current money-printing plan will take total assets above $3 trillion. At that level, it only takes a 2% decline in asset values to wipe out the Fed’s capital. Put differently, it only takes a 2% drop in the average value of assets on the Fed’s balance sheet for the Fed to go bankrupt. And this is in an environment where various markets frequently go up and down 3% in a single day.

The Fed is saying don’t worry about mark to market losses because we will hold the bonds. The Fed is saying don’t worry about inflation because we will sell the bonds. Both of those statements cannot be true at the same time. You can hold bonds and you can sell bonds but you can’t do both at once. You will want to sell when rates are going up but that’s when losses will be the greatest. So the time when you most want to sell is the time when you will most want to hold.

So, here’s the bottom line on money printing, or QE if you prefer. If nothing happens, the whole thing was a waste of time. If inflation takes off, the Fed will have to choose between holding bonds and letting inflation get worse or selling bonds and going bankrupt in the process. Since no entity goes down without a fight, the Fed will naturally hold the bonds and let inflation take off. Do not ask about the exit strategy from QE; there is no exit.

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