Tuesday, July 19, 2011

The FED : more leveraged now than Lehmans brothers

From gainspainscapital

The 2008 Crisis occurred when private US banks became so distrustful of one another’s balance sheet risk that interbank liquidity dried up triggering a systemic implosion in the unregulated derivatives market, particularly in Credit Default Swaps (which was a $50-60 trillion market at the time).
The Federal Reserve dealt with this situation by suspending accounting policies (permitting banks to lie about their true balance sheet risk), offering to backstop those banks with the greatest derivative exposure (JP Morgan, Bank of America, Goldman Sachs, and Citigroup), shifting trillions of dollars’ worth of toxic debt to the US balance sheet and then funneling trillions of new dollars into the banks most at risk of a derivative collapse (the banks I listed before).
From a philosophical perspective, the Fed removed the notion of “risk of failure” from Wall Street’s collective mind. As anyone who’s studied human behavior can tell you, without consequence for one’s actions most people will take their bad behaviors to the limit.
As a result of this, Wall Street went back to doing what caused the Financial Crisis in the first place: increasing leverage, fleecing clients, and paying its employees’ excessive salaries. Today the financial system is once again overleveraged. In fact, leverage levels today exceed those that occurred during the 2008 Tech Bubble, the large banks continue to be insolvent due to their gargantuan derivative exposure.
Put another way, the financial system is primed for another 2008 episode. The very same issues that caused 2008 remain in place. Leverage is far too high. And the unregulated derivatives market remains a multi-hundred trillion dollar problem.
However, the next Crisis will not simply be another 2008. The reason for this is that by transferring trillions in toxic debt to the public balance sheet, the Federal Reserve has put the US’s credit rating and debt situation in jeopardy.
To be clear, the US was already bankrupt due to unfunded liabilities (including Social Security and Medicare, the US has over $50 trillion in debt). But the Fed’s actions truly brought things to a tipping point.
Consider that before the Financial Crisis the Fed’s balance sheet consisted of $800 billion worth of Treasuries. Today, thanks to QE 1, QE lite, and QE 2, it’s $2.8 trillion. To put that number into perspective, it’s larger than the economies of France, the UK, and Brazil.
Remember, most if not ALL of this increase was the result of the Fed taking on DEBT (and toxic debt at that). With only $51 billion in capital, the Fed now has a leverage ratio of 54 to 1. To put this into perspective, Lehman Brothers was only leveraged at 30 to 1 when it went bust.
To say that the US Federal Reserve is now insolvent would be a gross understatement. The only reason anyone trusts the Fed today is:
1)   Tradition (it’s backstopped the system since 1913)
2)   The Fed has a printing press which means it can create money out of thin air
3)   Lack of alternatives (what other entity in the US has a printing press?)
And the only reason the US financial system and currency haven’t already collapsed is because other countries are in even worse shape and on the verge of collapse themselves (see Europe, China and Japan… China is rapidly heading towards a subprime crisis of its own).
However, this relative appeal (the US, while bankrupt, is in better shape than other countries) does not mean the US will avoid taking its medicine. That medicine will consist of some kind of debt default/ restructuring and a collapse in the Federal Reserve banking system. Put another way, it will mean an end to our current monetary system.
This process will involve bank holidays, severe market dislocations and crashes, temporary food shortages and consequent civil unrest.

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