Wednesday, January 11, 2012

The World's Biggest Hedge Fund

The world's largest hedge fund paid $79.3 billion dollars to its main investor last year, as announced to the press and reported by the Wall Street Journal this morning.

It followed classic hedge-fund strategies. It's leveraged about 55 to 1, meaning that for every dollar of capital it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that money to make aggressive bets in long-run government bonds, as well as strong speculative positions in mortgage-backed securities and direct distressed lending. Lately it's been putting bigger bets on loans to Europe and currency swaps. (Balance sheet here.)

The payout was actually conservative, as it reflected only the greater interest payments earned on its portfolio of assets and realized gains, not the substantial unrealized capital gains it made over the last year as long-term bond prices rose.

Who is this miraculous fund? Why our own Federal Reserve of course! 

Is this good or bad?

One argument for "good" was made famously by Milton Friedman. Commenting on central bank's interventions in currency markets, he pointed out that the central bank, like any trader, contributes to stability of asset prices if it makes money by trading. If you successfully buy low and sell high, then your actions raise prices in bad times and dampen them in good times. The usual practice of defending currencies and then giving in and devaluing them has the opposite effect.

By that measure, our Fed scores well so far. (I'm presuming here that price stability is desirable, which purists may quibble with, but let's not go there right now.)  On the other hand, we also know not to evaluate long-term portfolio performance with one good bet.

There is also no return without risk. Any trader who makes a superbly good return in one period is taking a risk of poor returns in the next. When (not if, when) long-term interest rates rise, the Fed will lose money on its portfolio of long-term bonds. If the economy gets worse, it will lose money on its credit risk portfolio. And so on.

Taking big portfolio risks is quite a change for the central bank. Traditionally, a central bank issues currency and reserves  and holds very short-term government or high-rated private debt. It earns a liquidity spread which it rebates to the Treasury. It does not take on substantial term or credit risk, and therefore it does not expose the Treasury to the possibility of losses.

(Some people think that central bank capital or portfolio losses don't matter. After all, it can always print money to pay its bills. That view is a fallacy. When the Fed needs to contract the money supply or raise interest, it needs assets to sell. Losses on its investment portfolio must eventually be made up by extra taxes. Benn Steil explains in more depth here and I'll come back to this issue if the comments section lights up.)

How much of a problem is the Fed's risk-taking, though?  In terms of overall debt and deficits, the Fed does not pose that much of a threat. Or, perhaps I should say, other things are worse. The Fed's balance sheet is "only" $3 trillion dollars. Even if it lost half of its assets, $1.5 trillion is one year's worth of Federal deficits,  10% of GDP, or 10% of the national debt. Losses on the Fed's portfolio are not going to bankrupt the country or send us to hyperinflation. The Treasury can sell bonds and give them to (sorry, "recapitalize") the Fed, and then raise taxes to pay off the bonds.  (That said, it would be nice to see a "stress test" on the central bank. Doctor, heal thyself.)

The real danger, then, is political, not financial. Imagine the fallout if the Treasury has to bail out the Fed to the tune of a few hundred billion dollars. The Fed would certainly lose a lot of independence.

Current thinking about monetary policy values the independence of the central bank.  An independent central bank is a way for the government to precommit ex-ante that it won't try to goose the money supply ex-post around elections. 

But the price of independence is limited authority. You cannot, in a democracy, have appointed officials with very long tenure writing checks to voters, allocating credit to specific industries, choosing winners and losers, or signing up the Treasury for trillions of dollars of tax liability.  The Fed cannot drop money from helicopters as Milton Friedman once recommended; that's called a transfer payment. The Fed can, in theory, only buy and sell safe securities of equal value. As dysfunctional as Congress and Administration may be, taxing and spending are their job, as they face the voters.

Of course, Federal Reserve actions have always had fiscal consequences. For much of history, the main role of central banks was to lower the interest rate on government debt, by making that debt more liquid.  And its "independence" has always been a relative thing as well. So as in many things, there is a sliding scale. But our Fed has certainly moved dramatically in the direction of actions with important, direct fiscal consequences. It must bear some cost of less independence as a result. We'll see what that is.

But potential portfolio losses strike me as a tip of the iceberg of actions that threaten the Fed's independence. The Fed participated in bailouts of specific companies and industries. It allocated credit to specific markets. In its expanded role as regulator it will be telling more and more banks how to run their businesses. It is now speaking more and more loudly about tax and spending policy, such as advocating mortgage bailouts. Its is setting "financial policy" more than "monetary policy."
The Fed is not likely to remain as independent in this expanded and very political role.

One thing is clear -- our monetary policy and central banking institutions are evolving fast.


  1. Nice post. What kind of accounting rules does the Fed follow? I assume that it’s not obligated to mark-to-market or to follow GAAP?


  2. How do you define "leverage" for an entity that can literally create it's own new money?

  3. Here's a question...shouldn't the Fed's portfolio risk be quite different from the risk that a private investor would take to hold the same portfolio, since the Fed can intentionally affect macro outcomes?

  4. I am a bit baffled by the comparison to hedge funds. These have outside liabilities in the form of debt most of which is short term, the Federal Reserve does not. How do you call a Federal Reserve Note or not roll it over? Inflation might result (of course that was the DESIRED motive behind QE) but as you write yourself, hyperinflation is a bogeyman. And for that matter, how do "investors" withdraw equity from the Federal Reserve?

    In this context I don't find the link to Benn Steil's blog post convincing. The Federal Reserve is part of the government. If the government implodes (Treasuries are worthless - as in his example) or the economy implodes (mortgage-backed securities are worthless), nobody expects the currency to remain unaffected regardless of the size and composition of the central bank's balance sheet.

    In addition the central bank clearly has other tools than open market operations to drain liquidity from the economy such as reserve requirements.

  5. Wasn't Alan Greenspan (and Paul Volcker as well for that matter) quite outspoken on many issues of finance and policy? I don't see a more expressly political Federal Reserve compared to the Greenspan era.

  6. Im missing why the Fed would ever need to be bailed out.

    Interest rates go up bond prices fall, the fed losses money. a few years down the line the fed needs to raise rates and soak up the money supply and it starts to sell assets for less then it purchased them for and it finds itself unable to sell its assets for the neccessary amount?
    At this point would the treasury need to give the fed debt to sell?

  7. Well, hedge funds don't leverage to 55-1, investment banks do. Typical leverage for hedge funds is 2-1.

  8. The Fed is different also because it does not need to worry about facing a margin call or that investors would redeem their invested capital.

  9. RE: After all, it can always print money to pay its bills. That view is a fallacy.

    The question is can the Fed create money for itself? It can create money to buy bonds because it has a liability account, a bank deposit account which to credit (increase). It is the reserve account, the deposit account at the Fed, of the bank from which it buys the bond. The debit side of the transaction is an increase to assets, Bonds. Debt asset Bonds, credit liability Bank Reserve account.

    (A commercial deposit bank has that same credit account so they create money when they loan. A finance company has to credit cash to lend money because it doesn’t have a liability account to credit so they can’t create money).

    What is the debit and credit for the Fed to give itself money? If they owe Office Depot $100 for copy paper, they can debit their own cash general ledger account. Who is to stop them? It is the Fed’s wire system so who is to stop them from sending a wire to Office Depot for $100. I can’t do that because I don’t own the wire system and my bank will require me to have a credit balance in my bank account (a debit balance on my books cash general ledger account).

    So what is the credit side of the transaction? Why can’t they simply credit capital? What is to stop them?
    If it can’t be explained in debits and credits then it is not understood. It is all thought experiments.

  10. Cochrane is a talented writer---but it saddens me to see the right-wing (usually the more sane of our two wings with respect to business matters) turn into a bunch of gold nuts and Fed bashers.

    If anything, the Fed has been passively tightening the money supply, first igniting the Great Recession (fighting commodities inflation, with exquisitely poor timing circa 2007-8), and then prolonging it (while pompously pettifogging about inflation).

    Japan has pioneered this type of monetarism, with rotten results that are epic in scale.

    Genuflecting to gold or worshipping an absolutely fixed value for paper currency (if that can even be measured) is only the facade of a monetary policy.

    The goal of monetary policy should be sustained prosperity--if inflation is flat, moderate, or we have mild deflation is less important than prosperity.

    It seems current-day Theo-monetarists place first the obligation to no inflation (with a type of asceticism seen in religious cults), and then prosperity a distant second. A great way to asphyxiate an economy.

    The Fed's QE program should have been more bold and sustained, and publicly telegraphed as such.

  11. I keep asking if the Fed is under-capitalized, and at its current 55:1 leverage ratio, it would put any private bank in the penalty box until it sold assets or raised capital.

    One bit of comfort in the situation is that the fed carries its gold holdings on its balance sheet at $42.22 for a total of $11 billion. At current market prices in excess of $1,600/oz., the gold is worth more than $400 billion. Writing it up on the balance sheet would cut the leverage down to about 7:1.

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