»The Daily Reckoning by Bill Borner

The US Fed is going broke
30 MARCH 2011

Los Angeles, California

She likes the free, fresh wind in her hair
Life without care
She's broke, and it's "oke"
Hates California, it's cold and it's damp
That's why the lady is a tramp

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Trading on the exchange has been suspended.

Television anchors -- the cheerleaders for the rally thus far -- are looking as though they have seen a ghost.

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Well, it's not cold and it's not damp. Instead, LA is warm and sunny, with springtime flowers popping out all over.

And yesterday, the Dow rose 81 points, while the price of gold slipped a little.

So what else is new?

We never thought we liked LA. But we may change our mind. Daughter Maria took us around yesterday. We wandered around Venice Beach and then through Hollywood. The town is much nicer than we remembered it. Many of the houses, shops and apartment buildings are getting a makeover. They remind us of the Soho area of Buenos Aires - young, hip, and lively.

"This isn't like the rest of America," Maria explained. "Just drive an hour to the East and you'll see what we mean. That's the real America. Here, the town is full of immigrants...pretty girls who want to hit it big in Hollywood...Russians, French, English...all sorts of girls. And there are a lot of men...you know, men who take a little too much care of themselves. You see them at parties. They also have a project. They always have contacts. They always have a cellphone and spend a lot time talking. But nothing ever happens.

"But I love LA. I don't know if I could live anywhere else."

There are a lot of girls with the fresh wind in their hair here...

And a lot of people who are broke. Whether it is "oke" or not...we don't know.

But here's the latest on America's housing meltdown:

AP - Damage from the housing bust is spreading to areas once thought to be immune.

In at least 14 major U.S. metro areas, prices have fallen to 2003 levels - when the housing bubble was just starting to inflate. Prices will likely drop further this year, making many people reluctant to buy or sell. That would push down sales and prices more.

The depressed housing industry is slowing an economy that has shown strength elsewhere. And it's starting to hurt those who bought years before the housing boom began. In some cities, people who have paid their mortgages for a decade have little or no home equity.

Prices have tumbled in familiar troubled spots, such as Las Vegas, Cleveland and Detroit. But they're also at or near 10-year lows in Denver, Atlanta, Chicago and Minneapolis - cities that weren't as swept up in the housing boom and bust.

"It's been tough on the lower class but it's filtering up," said Paul Dales, senior U.S. economist with Capital Economics. "It may be only a matter of time before it hits the wealthy." Just about the only major market weathering the second wave of the housing downturn is Washington. Home prices there have risen 11 percent in the past two years.
A Daily Reckoning note: the zombies are doing just fine, thank you. It's the rest of the nation that suffers. Money flows from the people who earn it to the protected financial sector...and to the feds themselves. It is any wonder that profits in finance are back to their 2007 level? Or that, overall, debt is now even higher? Or that people in the zombie capital are actually richer today (thanks to automatic wage hikes in the federal government, plus property value increases)?

But people in LA? In Chicago? In Dubuque or Baton Rouge?

They're broke.

*** Speaking of America's central bank, our colleague in London, John Stepek, says the Fed is going broke:
"Let's start with the balance sheet. A bank's assets are mainly loans made to individuals, businesses, even governments. Loans are assets because they are money owed to the bank.

"Now let's talk about the other side of the balance sheet - the liabilities. Most of the money a bank lends to customers comes from money that the bank itself borrows. It can borrow from you and me through the savings we deposit. It may also borrow from companies that place cash on deposit. And the bank may borrow from investors - insurance companies, pension funds, even other banks. All of these are liabilities - debts the bank owes to someone else.

"The other main item on the liabilities side is capital. Suppose the bank collected all the money owed by the borrowers. And then repaid all the money it owes. Capital is the money left over. It is the bank's true value.

"The balance sheet must always balance. So capital + debt = assets.

"Banks make money by lending at higher interest rates than they pay to borrow. Borrowers want long-term loans, usually at fixed interest rates. On the other hand, depositors want easy (short-term) access. And depositors often prefer variable interest rates.

"So this is the crucial role banks play in the economy. They take short-term variable rate savings, and recycle them into longer-term, fixed-rate loans.

"And this is where the problems of the world's third-largest bank start.

How a bank goes bust From the point of view of a bank, when interest rates rise, the value of a fixed-rate loan falls. The bank receives less income from that fixed-rate loan than it could now get elsewhere.

And interest rates on US ten-year government bonds have indeed been rising. Since last August, they've risen by about one percentage point.

Now, accounting rules dictate what happens next. Under certain conditions, banks must mark down the value of these loans. That's called 'marking to market'. And when it happens, capital also falls - otherwise the balance sheet doesn't balance any more.

But the world's third-largest bank doesn't follow the same accounting rules as every other bank. It refuses to restate the value of its assets. That's why they're surely worth less than the reported figure. In fact, if I'm right, the bank has no capital left. It has zero value. It's bust.

I can't prove this. But here's why I think I'm right.

$1.14 trillion (45%) of this bank's assets are fixed-rate loans of ten years or more. Let's suppose the ten-year bonds pay interest of 4%. If the yield rises to 5%, the price falls by about 8% (bond prices fall as yields rise). If yields rise to 6%, the price falls by 16%.

I don't know exactly when the bank made these loans. So I don't know the current yields or prices. But I do know that US government bond yields have risen by one percentage point since last August. And I think they'll keep going up.

So it's a fair bet that the bank's ten-year loans are worth less than it paid for them. An 8% loss on $1.14 trillion is $91 billion. And that excludes any losses on the $1.41 trillion of shorter loans that it holds, which are also affected.

This bank has been lending like the credit crunch never happened.

Of course, bank capital (as well as loss reserves) is designed to cushion against such losses. Since the credit crisis, most banks have reduced their lending, boosted reserves and raised more capital.

But not this bank. It carried on lending like the crisis never happened. Worse still, it has no loan loss reserves. And it's not raised a cent of extra capital.

Want to guess how much capital the bank holds against its $2.55 trillion in assets? $53 billion. That's just 2% of total assets. So a 2% fall in the value of those assets would wipe out every last dollar of capital. So it may already be insolvent. If not, it soon will be.

Have you guessed which bank I'm talking about? It's the US Federal Reserve Bank itself.

The Fed is bust - and that's not just my opinion

I'm serious. It may be the US central bank, but it's still a bank like all the rest.

Most of its assets are US government bonds, bought as part of its quantitative easing (QE) programmes.

Its liabilities include about $1 trillion of notes and coins in circulation. There are also $1.4 trillion of deposits owing to US commercial banks, which are required to hold reserves at the Fed. There are also some deposits owed to the US Treasury. And there's $53 billion in capital.

So the Fed can go bust just like any other bank. And I'm not the only one saying it. William Ford, a former president of the Atlanta Federal Reserve, one of the 12 member banks of the Fed itself, broke ranks to warn about it on 11 January.

Ford points out that the Fed can hide insolvency because it does not mark its assets to market. So we'll only know that it's bust when it sells some bonds. Only then would it have to take the losses from selling them for less than it paid.

Of course, the Fed going bust would be very embarrassing. So you can be sure it will be quietly bailed out behind closed doors. In fact, if the bail-out is timed to coincide with the losses, we might not even notice.

Who will bail out the Fed?

Why does this matter to you? Well, guess who would rescue the Fed? The US Treasury, a department of the US government, would have to inject extra capital to restore solvency. But the US government is not exactly flush these days.

So how would they get the money? They'd issue more bonds. And the Fed would buy them as part of its QE programme.

So let's be clear. The Fed goes bust. So it lends money to the US government (i.e. it buys US bonds), and the US Treasury gives it back to the Fed as capital. So the Fed is printing money to bail itself out. What do you think this will do for investor confidence in the US government and the dollar?

I'm pretty sure that the value of US Treasury bonds and the dollar will be worth less afterwards. And that's why you should have 8-12% of your portfolio in gold. It is sound money in an era when most currencies are not. It is insurance against further debasement of paper money.

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