WEAK USFED FINANCIAL CONDITION

◄$$ USFED INSOLVENCY COULD RENDER ATTACKS AND SCRUTINY AS MOOT, SINCE THE USFED IS TRAPPED $$$. The USFed holds on its balance sheet a wide assortment of basic garbage, a result of its diligent efforts to deal with the financial crisis. No toxic asset was turned down for acceptance and swap. It is now exposed to a significant amount of both credit and interest-rate risk. The USFed has made public its consolidated balance sheet as of May 27th, as part of a new monthly report on its Credit & Liquidity Programs. It claims assets of $2.082 trillion and total capital of $45 billion. The maintained capital ratio to assets stands at a miniscule 2.16%, below its own 4.0% target for tangible equity capital ratio. Bear in mind that its assets are probably greatly exaggerated, since illiquid in nonexistent markets. Its Tier 1 capital ratio is near 4.9% under common methods. The USFed has committed to expanding its mortgage portfolio to $1.2 trillion from its current size of $428 billion. This would reduce its Tier 1 capital ratio to 3.6%, under the same methods. The USFed cannot increase its capital account, except to retain more of its earnings, and not return funds to the USDept Treasury. The USFed cannot engage in a stock offering since a private firm.

Continued monetization and abuse of credit derivatives could destroy all the USFed capital. The risk of small changes in interest rates could easily eliminate the USFed capital under true market value. For example a 1% increase in interest rates would reduce the USFed capital by 38% if assets were marked to market, thus require liquidation managed by the FDIC, if it were a bank, a mere mortal financial firm. An exit strategy to remove a portion of its balance sheet would move interest rates by even a relatively small amount, thus threatening insolvency of the USFed itself. A sell program of their deeply impaired (often toxic) assets would instantly reduce their assets, force proper valuation, and also threaten insolvency. THEY ARE TRAPPED BY THEIR OWN SIZE, RISK, AND TOXIN. The other huge kill factor for the USFed pertains to duration. The USFed can remain technically solvent as long as the duration of its liability flow is substantially greater than the duration of its asset flow. Mortgage pre-payments work to harm their balance sheet by altering duration of liabilities. Even mortgage modifications are impossible without doing great harm to their duration. If they raise interest rates to ward off price inflation, they will also narrow the gap between the duration of the USFed’s assets and liabilities. A rate hike would increase the risk that its capital will fall below acceptable levels. An examination by credit analysts shows the USFed balance sheet is almost failing this test now. Public disclosure or formal audit revelations could result in a grand headline: THE USFED IS BROKEN, BUSTED, INSOLVENT.

Here is some strange irony! If the USFed marked its assets and liabilities to market, its gold hoard would also lift its balance sheet. Such an accounting change would add about $150 billion to the carried book value of the USFed gold. So disclosure would subject the USFed to scrutiny as the gold price fluctuated. More importantly, it would certainly enhance the market view of precious metals as a true bank asset, strong ballast immune to credit writedowns. See the fascinating tour of the USFed balance sheet analysis on the Ritholz article (CLICK HERE).