Fed looks like one more shaky bank

By Jim Jubak

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.

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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.

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.

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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.

"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.

Continued: Bulking up on commerical paper

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