Prepare for a New Banking Regime

TheStreet.com

NEW YORK (TheStreet) -- One hundred years later, the Federal Reserve System now may be the single largest, grievously wounded financial entity on the planet. As pent-up stresses unfold, the combined Fed (all of its banks) ultimately may not survive a tough "independent" audit as of Dec. 31, 2013, without a massive equity infusion.

According to its 2012 Annual Report, Federal Reserve banks combined have total "equity" of $54.7 billion compared to total assets of $2.917 trillion. Their ratio of stated equity to assets was, at Dec. 31, 2012, a skimpy 1.88%. By comparison, JPMorgan's ratio was 8.05%; Goldman Sachs' was 8.07%; Citigroup's was 10.24%; Bank of America's was 10.72%; and GE Capital's was 15.32%.

This surface-level comparison does not raise red flags high enough.

Financial statements issued by the Fed are not audited using comparable techniques employed for publicly traded financial institutions. Moreover, these tougher approaches did not catch evident problems before and during the crash of 2008 and 2009.

Assets held and liabilities owed by the Fed are not marked to market and not matched in maturity.

Since Dec. 31, 2007, total assets have increased from $847.3 billion to $2.917 trillion -- by 244.3%. During this time period, average yields on 10-Year Treasury securities were 2.94%. By comparison, from 1962 through 1999, yields on 10-Year Treasuries averaged 7.53%.

How large is the implied net markdown on Fed assets and liabilities, assuming benchmark yields settle upward, closer to pre-2000 norms, and that the Fed is forced to match maturities of assets and liabilities more closely?

If the Fed has "hedged" against the risk of sudden increases in benchmark interest rates, what happens to counterparties and to the global system when the Fed comes calling to collect on its hedges?

Profound change will result, as pent-up structural stresses continue now to erupt.

Contours of the Impending Bailout

Though debt securities are easier to understand than equities and commodities, investors have failed to concentrate upon alarming realities in the U.S. debt market, at their great peril.

Unlike September 2008 through May 2013, yields on benchmark 10-Year Treasuries continue to soar as challenges mount throughout the global economy. Put simply, securities issued by the U.S Treasury and core holdings of the Fed are no longer the safest port in the storm.

Professional investors understand the "game" that propped up the U.S. debt market, and by extension, the global economy, is kaput. The Fed and other allied Central Banks can no longer suppress overnight interest rates, encourage allies to borrow at these low rates, and then urge them to purchase higher yielding sovereign debt. The "duration miss-match" trade, the one that was the cause of the "subprime" crisis, can no longer work.

To see the essence of our collective problem, consider this. From 1962 through 1999, the annualized overnight borrowing rate for "connected" financial institutions (the "Effective Federal Funds Rate") was 6.81% or 90% of the average yield on 10-Year Treasuries.

By comparison, Fed Funds averaged 0.145% or just 5% of yields on 10-Year Treasuries that averaged 2.77% during the four years from 2009 through 2012.

It cannot make sense to continue borrowing at rates so far below "inflation," while encouraging investment of these borrowed funds in longer-term debt securities, issued by a Federal government that has proven its dysfunctionality beyond all reasonable doubt.

Is there a solution?

I suggested one approach in February 2013, in the Washington Times.

It starts with a return to a sound dollar; tough, comprehensive and regular audits of the Federal Reserve System; and a trillion dollar commitment to inject common equity inside the Fed, sourced by proceeds from orderly sales of federally owned lands and natural resources.

Over one weekend or another, and in months, not years, the largest bailout ever seen could soon come and it will not technically "work" for the United States because the Fed will ultimately surrender its exclusive right to direct traffic in the global financial system.

The Phoenix That May Rise From the Ashes

Remarkably, leaders in erstwhile anti-capitalist nations such as Russia are now practicing economic common sense. Amazingly, Vladimir Putin, reputedly a man of enormous first-generation wealth, is enforcing low, flat tax, capital-friendly policies that are thousands of miles geographically to the right of Democrat and Republican policies inside the United States. It cannot be much longer before leaders in rising nations, sovereign wealth funds, and pioneering investors decide to create a new, mammoth financial institution that will supplant the existing market for opaque, fiat currency debt securities with a market for term deposits whose interest rates are linked to price changes in brackets of essential commodities.

Unlike existing supra-national financial institutions whose track records and management teams are subpar, this new entity will set standards for full and fair disclosure and actually operate using ethical best practices.

Its assets will consist only of items whose intrinsic value can actually be assessed. Moreover, the term structure of its liabilities will be matched more closely to underlying assets.

It will purchase "under valued" securities and it will express "short" positions against "over valued" securities.

It will publish research identifying securities it believes are most under- and over-valued and only act after a reasonable cooling-off period has passed.

I imagine this new entity will launch with initial equity capital greater than any existing entity -- say, at least $250 billion -- and that its ratio of equity to assets will be maintained on a mark-to-market basis of not less than 20%.

Because most financial institutions are much weaker and because no custodial entity can ever be as strong as this new institution, I expect it to create an allied custodial subsidiary with one important difference. All client funds will be thoroughly vetted and operate continually conforming to best practices for disclosure and for prudent risk-taking.

According to BCG, global wealth stands at $223 trillion or 3.1 times global GDP at official exchange rates.

This wealth truly deserves a safe home.

Read more at The Rich Get Richer: Top 1% Control $52.8 Trillion or 39% of World's Wealth and the CIA's World Book of Facts.

At the time of publication, neither the author nor his firm held any positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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