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The most interesting part of yesterday's testimony by Chairman Ben Bernanke before the House Financial Services Committee is unlikely to be reported anywhere else. Late into an unusually uneventful question and answer period with the Fed Chair, Congressmen Scott Garrett finally livened the room up with an excellent question regarding Fed solvency.

Background: The Solvency Crises Facing the Fed

Many do not realize that to some extent the Fed reports a balance sheet in a similar fashion to any company, with assets, liabilities and capital/equity. The Fed takes unusually large liberties in how it values its assets, but nonetheless concedes some valuations on these financial line items.

The Fed's balance sheet at present is precariously standing on a very low capital level (assets minus liabilities). While the Fed has massively expanded its asset holdings, from a few hundred billion before the crisis to now over $3 trillion, the Fed's capital has failed to grow. This is partly because the Fed remits its excess earnings back to the Treasury and pays a dividend to the private banks who hold shares in the Fed. An added reason for the Fed's low capital is due to the fact the Fed is frequently front run on its purchases as announcements predate action. The failure of the capital in the Fed to grow while outstanding assets rise leads to an increasing leverage within the Federal Reserve system.

Fed Balance Sheet at a Glance (values in millions of dollars)

Assets Liabilities
Gold certs11,037Federal Reserve Notes net of Banks Holdings1,127,723
SDR certs5,200Reverse repos93,121
Securities, repos & loans2,844,229Deferred cash items1,640
Maiden Lane, TALF Portfolios1,990Other liabilities and dividends11,224
Items in collection process573
Bank premises2,308
Central Bank Swaps5,192
Other Assets224,068
Total Assets3,096,802Total Liabilities3,041,820
Total Capital/Equity54,982

Leverage is calculated by dividing equity by assets, to determine by what multiple a percent change in assets will impact capital. Say the Fed was leveraged 10 to 1, having $1 billion in capital against $10 billion in assets. If the Fed loses 10% on its asset holdings, -$1 billion, then this wipes out 100% of its capital. Since 10% loss on assets led to 100% loss on capital, a 10 to 1 leverage ratio is used to describe this capital sensitivity to asset losses.

At present the Fed is leveraged a whopping 55 to 1. This means even a modest 2% loss on the Fed's assets will wipe out its entire capital base:

Image shows Federal Reserve Leverage against the Average Leverage of Financial Institutions: (click to enlarge)

There has been a lot of uncertainty as to what the Fed going insolvent actually means. Traditionally central banks are supposed to be self-funded, their expenses are meant to be paid out of interest earnings. In times where the Fed has been or is anticipated to be short on capital, the Treasury has provided supplementary financing to the Fed.

The threat of a Fed insolvency is more a political issue than anything technically impairing to the Fed in terms of continuing operations. The Fed's liabilities are not redeemable so they can never become cash flow insolvent in a bank run environment one normally associates with a bank bankruptcy. The Fed has infinite power to issue further liabilities so is in no way technically restrained by having the capital wiped clean. The Fed can easily fund operations internally by issuing liabilities, though indirect routes are more likely to be taken to skirt the political mess associated with such a scenario.

Whether the Fed can legally operate without seeking financing from the Treasury in the event its capital is wiped thin is the biggest question that still remains. I wish this would be addressed to the Fed chairman, or preferably the Fed's legal counsel directly so we can finally validate where the Fed stands given a capital deficiency.

Bernanke Says Insolvency Does Not Matter

In the video exchange below between Congressmen Scott Garrett and Fed Chairman Ben Bernanke, the Fed chair revealed that a defunct Fed capital base is 'irrelevant.' The chairman claims the Fed is sitting on unrealized capital gains and some other mysterious source of funding that will assist the Fed given a capital shortage. Moreover, the Fed argues that even if the Fed has no capital, the issue is irrelevant as Fed liabilities are non redeemable.

As for the Fed's capital gains, this is really a meaningless factor. The Fed is the major purchaser of the assets it holds, so just because it is willing to pay higher prices for similar assets to what it owns already, does not mean a major liquidation of those assets would fetch a similar price in the market outside the Fed. In fact, estimates are that the Fed may lose hundreds of billions upon liquidation of the assets based on the same stress test factors the Fed uses to analyze banks.

See the full video exchange between Scott Garrett and Ben Bernanke.

A Fed Bankruptcy Can Destroy Fed Credibility, Impacting Asset Prices

Assuming there is no legal ramification, and the political environment is accepting of a bankrupt Fed, why should any of this matter? Simply put there is a grave impact on monetary policy operation based on whether or not the Fed has absorbed capital losses. The Fed's asset levels in relation to liabilities represent the prowess of the Fed in selling assets and absorbing back liabilities. Should the Fed want to reign in liquidity by calling back its liabilities, it needs to supply assets of equal worth to maintain full control over its liabilities. If the Fed's asset won't fetch an equal amount in liabilities in the marketplace, the liabilities issued by the Fed are then stuck in the system and the Fed is marginally more impotent in the conduct of a tightening policy.

With the Fed less able to tighten liquidity, the Fed's credibility is likely to wither and inflation expectations are likely to rise. This can have a grave impact on asset prices and precious metals, like the price of gold, also reflected via SPDR Gold Trust ETF (GLD), which would certainly react strongly from its own perspective.

If the Fed absorbs significant losses, a confidence crises in the currency may develop, driving precious metals to unthinkable heights. If you foresee such an event, it is wise to hold some hard asset or strong exposure to a hard asset just as insurance against this scenario. Consider purchasing physical precious metals, going long UGL or short GLL, and perhaps tapping into other metals like silver (SLV) to profit from rising metal prices.

Source: Bernanke Claims Fed Bankruptcy Is Irrelevant