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The Fed
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On the Origin of Facts

Fed looks like one more shaky bank

After gobbling up the questionable collateral of the financial giants, the central bank's vaults are filled with paper assets that likely aren't worth what they once were.

MSN Money

Citigroup (C, news, msgs) is too big to fail. American International Group (AIG, news, msgs) is too big to fail. So is Bank of America (BAC, news, msgs).

If $25 billion is not enough, shovel in $20 billion more in taxpayer money. Still not enough? Guarantee that taxpayers will pick up the tab for losses on $100 billion, $200 billion, $300 billion in shaky assets. There's no choice, right? Keep shoveling the cash into the black hole, because if we stop, the whole U.S. economy -- wait, make that the whole global economy -- will fall into disaster.

But how about the Federal Reserve, the key conduit for so many of these taxpayer billions? Is it too big to fail?

Bet you've never even thought about that question. Or what it means to anyone who lives in the United States. But you should.

A fistful of IOUs

The Federal Reserve's balance sheet increasingly looks like that of Citigroup or Bank of America. The Fed has extended loans backed by $200 billion in consumer and small-business loans and by $73 billion in assets from Bear Stearns and American International Group. It has extended loan guarantees of almost $300 billion to Citigroup and Bank of America.

As a result, its vaults aren't stuffed with the customary gold notes and U.S. Treasury bills, notes and bonds. Instead, they're piled high with paper assets without ready market prices that everyone suspects aren't worth what they were when the Fed accepted them as collateral.

The central bank is using theoretical valuation methods, often with considerable wiggle room, to price what it owns, just as Citibank and Lehman Bros. (LEHMQ, news, msgs) and Washington Mutual (WAMUQ, news, msgs) did. It has relied on credit ratings from the same rating companies that performed so dismally in the run-up to the current crisis to justify the value it claims for that paper. It has created specialized investment vehicles, just as Citibank and State Street (STT, news, msgs) did, in an effort to leverage a relatively modest amount of cash from the Treasury by 10-to-1.

What's the Fed to do?

Looking at all this, anyone who has seen this crisis take down what were once assumed to be rock-solid financial institutions, capable of surviving any crisis, has to ask whether the Federal Reserve really is too big to fail.

And the answer isn't nearly straightforward enough for investors and taxpayers who like to sleep soundly at night.

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Technically, of course, the Fed can't fail. It can tap the Treasury for huge sums of capital, and the Treasury can print money in amounts limited only by the willingness of savers and investors from Boca Raton to Ulan Bator to lend the U.S. government money. So the Fed isn't about to run out of money or to issue an urgent plea for more capital.

But even the Federal Reserve has financial rules it must follow that, in theory, prevent it from borrowing forever. And the Fed looks like it's getting perilously close to breaking some of those rules. That would force it to choose whether to lie about its balance sheet, to get "emergency" dispensation to violate the rules or to refuse to participate in the next round of "solutions" to this financial crisis.

None of those is an especially attractive alternative.

Damage could be broad and deep

To boil it down, the Fed is getting close to decisions and actions that could do substantial damage to the economy and the government's finances in the short run by making it harder for the United States to sell its debt to increasingly skeptical domestic and international investors.

And in the long run, the Fed is looking at the potential destruction of a huge hunk of the credibility that the U.S. will need if the country is to finance the huge deficits that are projected to last for decades. In the current crisis, the U.S. has had no difficulty in financing hundreds of billions in debt at ever-lower interest rates, as investors decided that Treasury paper was a haven in a dangerous world.

Anything that threatens that decision and leads investors to demand higher interest rates, rather than accepting discounted rates, would raise borrowing costs just as the U.S. is projected to need to sell trillions in new debt.

Higher interest rates for the U.S. government would feed into higher interest rates for U.S. companies and consumers, and slower economic growth and lower living standards for us all.

Fed is diluting its assets

The Federal Reserve Act of 1913, the law that created the central bank, authorized the creation of Federal Reserve notes -- the green stuff in your wallet -- as legal currency. (And yes, I know that some folks think the law and the Fed itself are unconstitutional, but I don't think anyone in Washington is going to open that can of worms in the current crisis.)

The Treasury's Bureau of Engraving and Printing produces these notes, but it's the 12 Federal Reserve banks that make up the system for dispensing and collecting that cash. Those 12 Fed banks must hold collateral equal to the value of any Federal Reserve notes they receive from the Treasury. Most of the time, the collateral held by the reserve banks is in the form of gold certificates and U.S. government bonds.

Bad news in the US leads to bad news in the United Kingdom and leads to bad news in Ukraine. And today’s bad news makes investors more likely to panic tomorrow, creating a cycle of panic, Jim Jubak says. (Jan. 22)

"The idea," the Treasury explains on its Web site, "was that if the Congress dissolved the Federal Reserve System, the United States would take over the notes (liabilities) . . . but the government would also take over the assets, which would be of equal value. Federal Reserve notes represent a first lien on all the assets of the Federal Reserve Banks, and on the collateral specifically held against them."

Any commercial bank that belongs to the Federal Reserve System can get Federal Reserve notes from the Fed anytime it wants, but it must pay for them, dollar for dollar, from the assets that it has on deposit with its district Federal Reserve bank.

Here's the crux of the problem: In an effort to fix the current crisis, the Federal Reserve is massively expanding its balance sheet while seriously diluting the quality of the assets on that balance sheet.

On Jan. 14, 2009, the Fed's balance sheet showed $2.1 trillion in assets. That supported $881 billion in currency in circulation.

That $2.1 trillion was a huge increase from the $868 billion on the Fed's balance sheet on Jan. 16, 2008. At $813 billion, the cash in circulation a year ago wasn't a whole lot less than what's in circulation now. As everybody from then-Treasury Secretary Hank Paulson to a newly inaugurated President Barack Obama has kept telling us, banks aren't lending. They're hoarding currency by keeping it on deposit with Federal Reserve banks.

Bulking up on commercial paper

Where did all the extra assets on the Fed's balance sheet come from? Ultimately, they came from the Treasury. And from expanding the definition of what kind of collateral the Fed would accept from banks seeking loans.

While the Fed's balance sheet was growing -- an increase of about 140% from January 2008 to January 2009 -- it was also deteriorating in quality. Way back in January 2008, about 84% of the Fed's balance sheet was made up of easy-to-sell, easy-to-price U.S. Treasury securities. By January 2009, Treasury securities made up just 23% of the Federal Reserve balance sheet.

What made up the rest of the Fed's balance sheet in January 2009, according to its own data? How about $335 billion in asset-backed commercial paper that the Fed had purchased because no private investor was willing to buy anything in the asset-backed commercial paper market. This commercial paper is backed by things such as consumer credit card debt and consumer car loans. How about roughly $74 billion in portfolio holdings from Maiden Lane 1, 2 and 3? This represents a loan the Federal Reserve made last June to the company to buy assets formerly owned by Bear Stearns.

Questions on the value of Fed assets

All of this paper is a lot harder to price than any Treasury security, especially right now. If it weren't, the Fed wouldn't be buying it, everybody would know what banks were really worth, and we wouldn't be in the midst of a horrendous financial system meltdown.

Fed watchers think that the real value of these assets is now substantially below what the Fed claims on its balance sheet. Last fall, the Fed said that, as of the end of September, the value of Maiden Lane 1 had declined to $27 billion from an initial value of $30 billion. Even though the Fed had lent only $29 billion on assets initially valued at $30 billion, it's likely that, given the huge and continuing write-downs from Citigroup and Bank of America, this paper is worth considerably less than its September price. The assets in question included securities backed by Alt-A residential mortgages and real-estate loans with credit quality slightly above subprime. Both asset classes have been falling in value along with a slowing economy. Maiden Lane 2 and 3 hold subprime mortgages previously owned by American International Group.

The Fed is due to report on the value of those assets sometime in the next week. It could report huge declines in the value of that paper, since AAA-rated securities backed by commercial mortgages fell 11% in the fourth quarter and A-rated securities fell almost 50%. That would raise questions about the size of the liability the U.S. taxpayer will eventually face from the Fed's efforts to support the financial system, and I'd expect to hear howls of protest from Congress and taxpayers if it turns out that these assets that the Fed accepted as collateral are now worth much less than their original values. Shouldn't the Fed have given the price of these assets a bigger haircut when it accepted them as collateral in order to protect taxpayers?

Fed's credibility is on the line

It's a question that will resonate loud and clear in Congress as the Obama administration thinks about buying up bad assets from banks in order to rescue the financial system. The sticking point in setting up such a program using what's called an aggregator bank has been what price the government should pay for these illiquid assets without reliable market prices. A big loss for the Fed certainly wouldn't make Congress more interested in throwing more taxpayer money down a rathole. Nor should it.

There's also a good chance that the Fed will cook the books by fudging the value of its assets. That's what private-sector bankers have done throughout the crisis.

Bad news in the US leads to bad news in the United Kingdom and leads to bad news in Ukraine. And today’s bad news makes investors more likely to panic tomorrow, creating a cycle of panic, Jim Jubak says. (Jan. 22)

As politically attractive as that course may be, though, it, too, has its long-term costs. If the discrepancy is too blatant, the decline in balance sheet values too small, then the Federal Reserve will have squandered a little more of what ultimately is its most valuable asset in ending this financial debacle: its credibility.

And once credibility is lost, it's awfully hard to regain.

Developments on a past column

"A better way to fight low yields": Will US Bancorp (USB, news, msgs) follow the lead of so many of its peers in the banking industry and cut its dividend? The question isn't academic to me: I had added this stock to Jubak's Picks in April 2008 because it then paid better than 5%.

Since the company's Jan. 21 announcement on fourth-quarter earnings, a majority of investors on Wall Street have been thinking the dividend is headed for a cut. A stock-price drop of 12.5% on Jan. 22 left the yield on the shares at 12.1%. You don't see that kind of a yield on a bank stock unless the market is convinced the company will cut its payout.

I can certainly see why investors think that. The bank didn't exactly give a ringing defense of the dividend in its earnings conference call. Executives said the company believes it will be able to cover the dividend from earnings in 2009 but noted that it reviews the dividend every 90 days -- which puts the next review in March -- and that the bank has no intention of continuing the current dividend if earnings don't cover the payout.

The real issue then, as the company said in its statement, is earnings for the rest of 2009. On Jan. 21, US Bancorp reported earnings of 15 cents a share. That's a profit -- unusual for a bank these days -- but still 7 cents a share below what Wall Street had expected. The problems? There were $253 million in losses on securities and a $635 million increase in provision for credit losses. All in all, charges and losses chopped 34 cents a share out of earnings.

It's also clear that the bank's business, like that of all banks I know of, is still getting worse. Nonperforming assets climbed to 1.14% in December, and the bank said it anticipated that nonperforming assets -- that is, loans that the bank can't collect on in a timely fashion -- will continue to climb in 2009. It's cold comfort to investors that the bank's performance continues to be so much better than other banks'. The increase in nonperforming assets to 1.14% in December is only a modest increase from the 0.88% in September. That indicates the bank's lending standards continue to hold up to a very difficult economy.

The bank's operating results, in fact, were quite impressive. Loans grew 17% (12.7% excluding acquisitions) and deposits 15.2% (9.6% excluding acquisitions) from the fourth quarter of 2007. (In November 2008, the company acquired Downey Savings and Loan and PFF Bank and Trust from the Federal Deposit Insurance Corp.) Net interest income grew 22.6%. Tier 1 capital remained at a strong 10.6%.

So will US Bancorp cut the dividend or not? Unfortunately, it's a danger and, also unfortunately, uncertain. It depends on how long the economy struggles and how big the losses get on the bank's portfolio of loans. I still think US Bancorp will be a winner in the current crisis, and this quarter's results are evidence that the bank is picking up loan and deposit volume as customers opt for the bank's relative safety.

I'd certainly be disappointed at a dividend cut, but I think the potential from here outweighs the damage that even a dividend cut would temporarily inflict. As of Jan. 23, I'm cutting my target price to $35 a share, from a prior $44 a share, and stretching out the schedule to March 2010 from December 2009. (Full disclosure: I own shares of US Bancorp in my personal account.)

At the time of publication, Jim Jubak owned or controlled shares of the following companies mentioned in this column: US Bancorp. He did not own or control short positions in any stock mentioned in this column.

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