The Federal Reserve is More Leveraged than Lehman Brothers was.

In Debt on April 8, 2011 by CQCA

Bank leverage is determined by dividing bank assets by stockholders equity. When a bank, or any company, borrows money to purchase an asset, it makes a bet that that asset will increase. If the asset does increase in value (or produces more income) both the assets and stockholders equity increase. However, if the value of that asset decreases, then any loss in excess of the stockholders equity begins to cut into creditors’ money.

Imagine I have $10 in assets, but only $1 is my own and $9 is borrowed. If that asset increases to $11, I now have $2 of my own and owe $9 to creditors. Because of leverage, I was able to double my money by purchasing something I was not able to purchase without borrowing money.

Now assume the value of that asset goes down to $9. I now have $0 and owe $9 to my creditors. Even though the asset only lost 10%, I lost 100% of my capital. So leverage can also be very dangerous.

The table above shows the degrees of leverage for various institutions. The average FDIC insured bank has a leverage ratio of 8.73%, or a leverage multiplier of 11.5. This means the average FDIC insured bank borrows $11.5 for ever $1 in assets, and would have to lose more than 8.73% of its assets to go bankrupt. Washington Mutual, which failed in 2008, had a leverage multiple of 13.4. Lehman Brothers was at 21.1. Surprisingly, the Federal Reserve has a multiplier of 50.5.

Yesterday the Federal Reserve released the Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks (April 7, 2011). The Federal Reserve’s equivalent of stockholders equity is simply called capital.

In total, the Federal Reserve has $52.5 billion in capital. Its assets include $937.1 billion in mortgage-backed securities, which are “Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. [The current] face value of the securities, […] is the remaining principal balance of the
underlying mortgages.” If 6% of them default, the Federal Reserve would suffer $56.2 billion in losses, which would place it in negative equity (insolvency). More than likely, the values of these mortgage securities are overstated, meaning the Federal Reserve is already insolvent.

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