Many financial disasters resulted from excessive leverage. Recent data show that the Federal Reserve is now using more leverage than Lehman Brothers, Bear Stearns or Long Term Capital did at the time of their collapse.
Leverage means investors, or more accurately high-risk speculators, borrow money to increase their returns. If a firm has $1 billion and can invest it at 5 percent, they could make $50 million dollars. If they can borrow another $1 billion at 2 percent, they could make an additional $30 million after paying the interest on their loan. If they can borrow $30 billion, they could earn $920 million on $1 billion of capital, a return of almost 100 percent a year.
That has been the point where failures have happened in the past. When you borrow $30 for every $1 you have, a loss of about 3.2 percent wipes out all of the capital you started with and makes it impossible to service the debt.
Like an investment firm, the Fed has a balance sheet and an income statement. That balance sheet shows a dangerous amount of leverage equal to 55 times the central bank’s equity. A 1.8 percent move against the Fed’s position, caused by an increase in interest rates, could leave the Fed needing a bailout.
The Fed made a profit of $89 billion last year on total equity of $55 billion, a profit of 162 percent. Fed Chairman Ben Bernanke has now become the manager of the largest hedge fund in the world and has taken on more risk than many funds that have collapsed.
There will always be money to bail out the Fed, but the cost to the economy will be high when that money is needed. It’s likely that higher interest rates and increased inflation could appear suddenly when the Fed stumbles and investors will suffer as the mother of all hedge funds works through its losses.
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