Tuesday, April 8, 2008

The Fed's Dowry Fund Is Running Low

If you assume that the Fed has nearly unlimited capacity to bail out the US financial system, you better think again. A look at the size and makeup of its balance sheet versus the "shadow banking system" is enough to send shivers down your spine. To wit, look at the chart below (click to enlarge):

Data: FRB

After providing a very generous dowry to JP Morgan for marrying Bear Stearns plus beauty salon money for the bridesmaids, the quality of the Fed's own balance sheet has deteriorated rapidly. Holdings of Treasury securities plunged from 90% to 65% of assets and will drop further as more ugly spinsters come asking for makeovers.

Furthermore, its Treasurys now account for a low 3.5% of the debt issued by the US financial sector, down from 8.5% in 1996. In gross terms, the Fed's capacity to provide bailouts to the financial system without resorting to the printing presses is 60% less than twelve years ago. And this is before we account for the considerably higher risk being carried by the financial system as a whole versus a decade or more ago.

I leave the conclusions, once again, to the informed reader.


  1. What conclusion will your uninformed or misinformed readers make?

    ~C. Maoxian

  2. This comment has been removed by the author.

  3. What are the odds that the fed resorts to fractional reserve lending? Is this permitted by its charter?

  4. In other words, informed readers should be: a) short Treasuries; b) short equities; c) short the dollar or d) all of the above.

    I'll wager the answer is "d".

    I'm running out of things to get short on.


  5. Run out!? LOL, (spits coffee and falls off chair)

    The FED is now constructing new powers to directly take over the Treasury. They run out, when we have a paper and electron shortage.

    Can you say Weimar?

  6. I think coffee-spitting anonymous is correct. Any rules that the shadow bankers even pretend to adhere to are about to be changed.

    Ever been cornered by a 5 year old and convinced to play a card game? They don't shuffle the cards, they deal out different amounts of cards to each player, the first hand you put down an ace against their jack so they win, next hand you put down a jack against their ace so they win again... then 3 days later you have some hideous kindergarten flu.

    The analogy here is that its a zero sum game with you ALWAYS losing.

  7. Now I know why my momma never let me play cards.. :)

  8. I have been reading analysis on other blogs (like Mish's) about Roubini's V,U,W or L shaped recession article. Do you have any thoughts on this yourself?

    @Econolicious, Dink and Anon... Accrued interest has an interesting posting today on just how useless macro numbers are for investors as predictive indicators of what and where to invest(even really bad macro numbers).

    Dink, at some level, everything is a Red Queen race, but your point really implies the Fed will one day not just 'swap' junk debt for Tresuries, but actually begin dropping 'helicopters' of money on the system-- and I am beginning to see Hell's point that the market is just too smart for this.

    Although... I will add Ben Bittrolff made the very interesting comment on his blog the other day that IF the Fed were to start printing, we would see capital controls instituted before they started. So I guess 'IF' you see capital controls instituted (like the kind Indonesia is now instituting for Rice), then I will send you a six pack of Anchor Steam beer and submit you are right!

  9. Hell- I'm sure momma realized early on that trouble was brewing:)

    a) I don't think that Congress/regulators are too cowardly or corrupted to stop the Fed from printing, I honestly think they don't understand the implications. Like many moral hazards, the horrors aren't obvious at the beginning.
    b) The Accrued Interest link didn't transfer me..
    c) I'm about 2/3rds through Origin of Wealth. Here's a great line from page 287- "If a tribe is generally surviving and the Big Man's graft, corruption, or incompetence isn't life threatening, then relatively few people may even be aware of the aditional wealth their tribe is giving up"

    Thought of the Day-
    "The truth will set you free. But first, it will piss you off."
    -Gloria Steinem

  10. Thank you so much Hellasious. Could you tell me where you got the historical series on the fed website, i only find weekly data.

    Thanks again and long life to your blog !


  11. Dink... What do you think about The Origins of Wealth so far? I loved that book.

    the accrued interest link is

  12. Thai-

    OoW:A well-crafted and informative book. My initial thoughts include 1)I have never come across the word "disequilibria" before, 2)there has got to be a way to model "Social Technologies" so they can evolve as quickly as Physical Technologies, and 3)in a tribe of 150 you can keep defectors in line, but in a huge population they aren't being monitored so are continually rewarded for their rat bastard behavior. How can we have trust and cooperation in groups over 150?

    On a side note- I remember being in an econ class 600 years ago and the prof kept saying "ceteris paribus" about hypothetical situations. It appears that those Santa Fe scientists called the economists on the carpet about that oh-so-convenient assumptions.

  13. Dink
    1. In what context?
    2. Like in Isaac Asimov's Foundation series, where he proposed the concept of Psychohistory?
    3. Ah Grasshopper, now you understanding the problem!... I tried to convey this to Okie the other day, but was sadly not so eloquent.

  14. Thai-
    1)The author was relating how the original economists tried to mirror physics (up to the point where quantum dynamics entered the scene)and believed prices "want" to go to an equilibrium point.
    2)I do love sci-fi including the Foundation series, but I was thinking of models like Karl Sim's Block creatures. That way we could quickly test various social structures without the time/resource waste. Example: I used to think if China kept artificially raising the male % of newborns, then females would be rarer and therefore better treated. It turns out females get treated worse and the males fight more. It would be nice to have a model were we could plug in variables, see the results, and avoid unforeseen consequences.
    3) I opened the "grasshopper" link. I may even be interested enough to shell out $4.95 to read the rest of the article :) Scientic American had an article last month about game theory and drug testing in professional bicycling, but I just skimmed it.

    Colbert fans- Did you catch his snark a few days ago? A guest said he had a surprising explanation for something. Colbert cut him off and said "Lemme guess. Fractals. Is it chaos theory?" I've said it before, but he's worth buying a TiVo for.

  15. Do you have the Colbert link?

  16. ollie,

    'Fractional reserve lending' is exactly the system which we have, which is also to say that we are and have been in a credit money system for quite a long time.

    One of the supply side determinants is level of reserve requirements which, as you can see from the attached chart, can have dramatic effects on the potential quantity of credit money created.

    Another supply side determinant is the degree of risk lenders are willing, or able, to take, i.e. lending standards are not fixed but tighten or loosen according to such things as the internal conditions of the lenders and/or perception of economic conditions going forwards. From this perspective it's easy to see that a lowering of the fed funds rate does not automatically translate into greater lending -- standards can tighten even as the fed reduces, and this has in fact been happening.

    Then, it matters not how low interest rates happen to be if borrowers have reached their limit to take on new debt. There are demand side limits (e.g. wages and profits) to the whole process of credit money creation.

    OK, more interesting, there has been a long run, multi-decade, deregulation of finance which has also promoted the rise of non-bank financial institutions or non-bank banks such as MMFs until, finally during the mid-later 1990s, a new and global non-bank bank/traditional bank hybrid had been created and a hybrid with the potential to create unlimited quantities of "money". I think it was in 2001 that Larry Lindsey aptly termed this "nuclear credit fission"; inother words, uncontrollability.

    But, contrary to some opinions, this is a for profit system; money is not given away, is not nor will be dropped from helicopters -- credit money creation is also debt accumulation and this latter comes into contradiction with ability to service.

    There are limits.

    The fed, by internalizing what may well be worthless collateral, is limited by its balance sheet -- it cannot absorb the total or even most without destroying itself while at the same time ending the dollar as reserve currency.

    As mentioned, borrowers are not able to take on unlimited quantities of debt.

    This whole thing has mathematical and real limits which are both external and internal to loan capital.

  17. The fed cannot create inflation. Only the government can by extravagant expenditure. All the fed can do is buy. It can buy things of value or buy junk. Currently it can only buy Ts or similar junk. It could go out and buy foreign currency, and there is where it could create inflation with the help of the federal government.

    Those currency swaps it issued a while ago, need to be looked at.

  18. Anyone interested in further clarification on fractional reserve banking might want to check out "Money as Debt" at


    It's a fun and entertaining video (47min) suitable for viewing with the kids (12&up). Prepare them early, we're about to live through interesting times.


    How do you think the Fed inflates?, by purchasing assets and paying for them by crediting the account of the seller. The Fed doesn't need the Treasury's help once a political decision has been made to inflate.

  19. Re How money is created, this is a good read on the subject, and not too long http://dkd.net/davekidd/politics/moneyapo.html

    Regards all.

  20. When ordinary folks step outside the system they are prosecuted, convicted and sentenced. When the folks who constructed a rigged system start to suffer the slings and arrows of outrageous (mis)fortune they do indeed try to change the game altogether.

    But I do recall what Joe Louis said before he fought and barely beat Billy Conn. "He can run, but he can't hide." So the piper must be paid, and at the moment, I don't see a settling of accounts via a Weimar like episode. But, as it is not beyond the realm of the possible, one should continue to hold one's gold and sequester their silver.

  21. Considering that an article was just released discussing the fed's unconventional options once it's balance sheet becomes overly impaired, you're recent blog post was very timely. Here's a link to the article (requires a WSJ online subscription I believe):

    Fed Weighs Its Options in Easing Crunch


  22. To: lili

    I extracted the data from the historical releases.



  23. I'm running out of things to get short on.

    It's just as well because I would not short anything right now -- the markets are very dangerous, and (perhaps this is stating the obvious) the deck is stacked against shorts (thanks to dink for the analogy).

  24. Thanks Hell, Dink, Thai, Yoyomo & Edwardo. Your posts & comments are rightly going outside-the-box on what the Fed & Treasury can do according to the current language in their charter, and current norms, precedents, rules & processes.

    Prior to 2006, I would have pooh-poohed the idea of them succeeding in changing charters and rules, etc, let alone doing so after the fact. I would say there'd be checks-and-balances on the Fed & Treasury.

    But 1) 2008 is an election year; 2) we have a very lame duck President; 3) we have a very unpopular Congress; 4) we’re destined to elect a President with a weak mandate/majority; and 5) a party that prides itself on disunity is likely to gain more seats in Congress.
    I think the public, Prez and Congress are too hobbled and befuddled to really challenge whatever the Fed & Treasury sell to them and us as the 'next step in curing this'.
    This is forcing me to invest less time reading analysis based exclusively on what the Gov't is 'allowed' to do under today's legal rules. Instead, I’m investing more time considering what rules are most likely to be 'broken' or spun.
    For now, I don't see this momentum-gaining wizardry & monetary policy alchemy creating a ‘fix’ that precludes no massive losses by today's wealth holders as well as the credit-card indebted 80% who live paycheck to paycheck. And I’m betting the ‘fix’ still passes on lumps and chunks of the problem to the next generation.

  25. Now that Fed ran out of ammo trying to save their banking buddies and they really cannot monetize en masse without dollar falling down like a lead. Even more so that recent attempts by Fed barely putting any dent on solving the credit problems.

    So Fed seems have no choice but to nationalize those stone cold broke banks/investment banks, thus wiping out the shareholders and depositor's accounts frozen (allow them for small monthly token withdraws). Surely better than letting them go fully implode. Then they gotta to deal with angry public.

    Bernanke would have to eat his words for breakfast, lunch and dinner.

    Looks like it is going to happen that way, make sense?