Hold Onto Your Seat!

The S&P is closing in on bear market territory, which is defined as a decline of 20% or more from recent highs.

And it may fall even further. Since World War II, there have been 14 bear markets. The median loss during these bear markets has been 30%, and they lasted about a year (hat tip to Bespoke Investment Group).

The Kind of Drop We Haven’t Seen in Decades

And with the Fed ready to raise interest rates again this week after last week’s red-hot inflation data, we could be soon witnessing an even bigger drop in the market — the kind that we haven’t seen in decades.

That’s not fear-mongering or hyperbole. It’s just a sober assessment of the situation.

The Fed is deeply concerned about inflation, and it will continue to aggressively raise interest rates to try to tamp it down. Most analysts are projecting a 50-basis-point rate hike on Wednesday, but the odds of a 75-basis-point hike have increased substantially after Friday’s inflation report.

Some are even projecting a 100-basis-point rate hike. Regardless, the Fed will continue to aggressively tighten for the foreseeable future.

But neither the economy nor the stock market can take the kind of tightening required to really get a hold on inflation.

Since the end of World War II, the Fed has embarked on perhaps a dozen tightening cycles in which it raised interest rates. All but one of these tightening cycles resulted in recession. That’s a nearly perfect record.

And there’s absolutely no reason to expect that this time will be any different, especially with the tremendous excesses within the financial system.

Which brings up the question, is the Federal Reserve broke?

How Can the Fed Be Broke?

When you bring up the topic of the Federal Reserve going broke, most individuals react by saying, “That’s impossible! The Fed can’t go broke. They can just print more money.”

That’s a typical reaction, but it displays a misunderstanding of what money is and how the Fed actually works. Yes, the Fed can print all the money it wants. But money is not an asset for the Fed; it’s a liability.

Take a $20 bill out of your purse or wallet and read it. On a banner across the top it says, “Federal Reserve Note.” A note is a form of debt; in other words, it’s a liability. That becomes clear when you look at the Fed’s balance sheet (it’s publicly available on the Fed’s website).

Assets consist mainly of securities: mostly U.S. Treasury bills and notes and mortgage-backed securities. Liabilities consist of cash, coins and reserves deposited by member banks at the Fed. The Fed’s net worth or capital is simply the net of the assets minus liabilities.

That equity account is a small sliver of capital relative to the total assets.

In other words, the Fed looks like a highly leveraged hedge fund. Printing money can be used to buy more securities, but all that does is leverage the balance sheet even more by piling more assets (securities) and liabilities (money and reserves) on top of the same sliver of capital.

But what if it’s worse than that? What if the assets are less than the liabilities so the Fed has a negative net worth?

Less Than Zero

A negative net worth is one definition of insolvency, which is a fancy name for broke. In the steady state, this would not happen. The Fed could just sit still; let assets mature at par value; and get paid the cash by the issuer, at which point the cash just disappears when the Fed receives it.

The Fed could gradually deleverage just by doing nothing. But what if the Fed balance sheet were marked to market like a real hedge fund? Or what if the Fed sold securities at a loss instead of just waiting for them to mature at par value?

The Fed’s accounting method does not mark to market, but any analyst can run the numbers anyway just by looking at asset maturities and using current market prices for those assets. If you do this, you find that higher interest rates have resulted in many securities in Fed’s portfolio being worth less than book value.

That’s bond math 101: higher rates = lower prices. Beyond that, the Fed does not want to wait to deleverage. It wants to reduce the balance sheet quickly. That means asset sales, especially the less liquid mortgage-backed securities.

That’s where real operating losses arise because an actual sale below par value results in a loss that must be charged against capital. So yes, the Fed is probably insolvent on a mark-to-market basis (a method it does not use).

A Fed Governor Admits the Fed Is Insolvent

If you evaluated the Fed on a mark-to-market basis the way you would with a hedge fund, its capital would be wiped out. It’s insolvent. I once had a conversation with a member of the Federal Open Market Committee who admitted this to me privately. I reached a conclusion on my own, but she confirmed it.

The conversation went like this: I said, “I think the Fed is insolvent.”

This governor first resisted and said, “No, we’re not.” But I pressed her a little bit harder and she said, “Well, maybe.”

And then I just looked at her and she said, “Well, we are, but it doesn’t matter.”

In other words, a governor of the Federal Reserve admitted to me, privately, that the Federal Reserve is insolvent but said it doesn’t matter because central banks don’t need capital.

Well, central banks do need capital.

She may be right in the short term that it doesn’t really matter. Most people don’t even know what the Federal Reserve is let alone the inside accounting issues I described here. But in the next panic, it just might matter.

Maybe Gold Is the Foundation of the Monetary System After All

The problem is each financial crisis is larger than the one that preceded it because the system itself is larger due to massive central bank interventions. It’s a matter of scale.

How can the Fed bail out big banks when the Fed itself is insolvent? The issue might not be a legal one so much as a matter of confidence.

Just in case, the Fed does have a hidden asset to offset all of those not-so-hidden losses. The Fed has a gold certificate on its books based on a quantity of gold valued at $42.22 per ounce.

If that gold were revalued to the current market price of $1,850 per ounce, another $500 billion would appear out of thin air. That could be added to Fed capital.

The Fed doesn’t like to talk about gold, but maybe the entire monetary system is based on gold after all.

One day we might just find out the hard way.


Jim Rickards
for The Daily Reckoning

The Daily Reckoning