QE2 to bankrupt Fed?

Jim Rickards, writing for KingWorldNews.com, exposes the risks that the Fed is taking with its second Quantitative Easing program, now aptly dubbed QE2.  According to Richards, the Fed could go bankrupt.  First, how the Fed could go bankrupt; second, why it will not happen, at least not immediately.

The Fed announced that it plans to implement QE2 with purchases of five-year to ten-year Treasury bonds.  The Fed buys the bonds by crediting the accounts of the banks from which it buy the bonds.  The bonds go into the Fed’s portfolio; the money goes into the banking system.  Ergo, the money supply is inflated, and—according to Keynesian economic theory—this will stimulate the economy.

The problem is, as Richards explains, five to ten-year Treasuries carry market risk.  When interest rates go up, the value of the bonds drops.  (Further, it’s significant that right now interest rates are at historic lows, which means they are more likely to go up than to go down or even remain unchanged.)  Here’s what Rickards fears:

Right now the Fed’s balance sheet shows about $57 billion in total capital.  Current assets are about $2.3 trillion.  The current money-printing plan will take total assets above $3 trillion.  At that level, it only takes a 2% decline in asset values to wipe out the Fed’s capital.  Put differently, it only takes a 2% drop in the average value of assets on the Fed’s balance sheet for the Fed to go bankrupt.  And this is in an environment where various markets frequently go up and down 3% in a single day.

Rickards further notes that “intermediate term securities are more volatile than short-term securities.  The Fed traditionally purchases Treasury bills of one-year or less in maturity.  Those bills are not volatile at all and don’t move much in price when interest rates change.  So, mark-to-market losses are never that great.  But 10-year notes are highly volatile and losses can be huge in response to even modest increases in interest rates.” 

Additionally, Rickards points out that the Fed holds questionable assets, such as the Maiden Lane portfolio of junk from Bear Stearns and $1.4 trillion of mortgages whose value is in serious doubt because of strategic defaults, lost notes and halted foreclosures.  So, the Fed’s $57 billion in total capital may be overvalued, making QE2 still more risky.

However, the Fed remains the issuer of not only our (the US’) currency, it is the issuer of the world’s primary currency.  As long as we and the rest of the world use dollars as the medium of exchange, the Fed can simply print, regardless of the value of its assets.

Remember also that other central banks are set to print so that their currencies do not rise relative to the dollar, which means inflation worldwide.  In which case, it’s a pick the currency you fear the least.  For individuals, the choice is easy, either gold or silver.  For governments, corporations and institutions that need currencies for day to day transactions, gold and silver do not work.

And, there’s still another concern.

If the world perceives that the Fed is on a “damn to torpedoes, full speed ahead” program with dollar creation, with QE2 to be followed QE3, QE4, QE exponential, the public cannot but be concerned about hyperinflation.  With gold and silver being the only uninflatable currencies, their prices will skyrocket.  Yet with gold and silver charging to new highs, it makes buying gold and silver at this time a gutsy decision.

Still, where are investors seeking protection from a massive debasement of our currency (and other major currencies) to go? 

Read Richards’s No Exit (for the Fed) for a better perspective on the ramifications of QE2.