Who will bail out the Fed?

A number of bloggers have been wondering about the health of the banking system's ultimate backstop, the Federal Reserve. As Barry Ritholtz at the Big Picture and Mike Larson at iStockAnalyst note, the Fed's balance sheet is falling apart, thanks to the acquisition of the same low quality paper that has driven American banks to the brink.

It's been a largely unstated assumption that the Fed has near infinite capacity to absorb toxic mortgage backed securities and corporate bonds, but the growing levels of low quality assets on the Fed's books bring that assumption into question. At some point, those bad assets will have to be dealt with.

By Larson's calculation, leverage at the Fed is approaching the dizzying heights seen in some private investment funds during the bubble years: "the Fed banks are holding total capital of just $45.7 billion against the sum total of $2.19 trillion in assets, meaning the Fed is leveraging its capital 48-to-1. That compares to only 27-to-1 two years ago." So leverage has nearly doubled in just one year, thanks to the acquisition of low-grade assets.

The implication is that the basic instruments of American economic power, especially Treasury securities and the dollar, are being weakened in the long run. If this is indeed the case, you might want to revisit some of the more dire scenarios that inflation hawks and gold bugs have been talking about for quite some time now. While it is certainly the case that the inflation hawks have been wrong so far -- as DailyFinance's Joe Lazarro and others have pointed out, deflation has been the greater threat in the economic crisis so far -- the increasingly precarious state of the Fed's balance sheet provides a hint that things could change somewhere down the road, and not for the better if you're betting on the strength of the American financial system.
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