The Fed has Become More Like the Banks that it Regulates

1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

2) Increase my interest spreads by ~50% over last year.


3) I only increased my profits by ~50% over last year??! I would have thought that profits would have more than tripled.

Such is life for the Fed. The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

My main point is that the Fed should have earned a lot more. Where did it all go? It will be interesting to see a detailed rendering of the Fed’s finances when this is done. Did they realize losses on some of the assets that they bought?

My friend Peter Eavis of the Wall Street Journal agrees. Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite. Alea knows more, but I like KD’s spirit.

The Fed has become more like the banks that it regulates. They are taking on credit risk, duration risk, convexity risk, etc. And being a government institution, they don’t have good incentives for knowing how to price risk.

So, when I see the Fed’s seniorage profits up only 50%, I am not impressed. The Fed doesn’t mark to market, so we really don’t know the true performance. Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses. Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well. Examples are numerous:

  • Investors including PIMCO, are flocking to European corporates, though generally only the stronger countries, not Greece, Italy, Ireland, Portugal or Spain. (Note: PIMCO will exit the trade at a better time than most imitators.)
  • Average people are willing to fund all of this as well, accepting low rates of return for the duration and credit risks that they take on. If the Fed wanted people to bid up bond prices to unsustainable levels, they have succeeded.
  • Finally, I suppose if one pours enough jet fuel on a soggy, rotten log, I suppose one could get it to burn. If the prices of non-GSE mortgage debt are rising rapidly, to me, that means speculation is getting out of hand. Financial leverage is even coming back to these markets. As with junk bonds, the markets are subject to two risks — that the cheap financing disappears, or that the likelihood of defaults becomes more obvious.

To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production). That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism. There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website ( Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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