Dec 6

Mr. Chairman, How Much Leverage is Too Much?

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Sunday night, as part of his ongoing efforts to add to communication efforts at the Federal Reserve, Chairman Ben Bernanke told viewers of the venerable 60 Minutes that the Fed would not hesitate to increase the size and scope of it asset purchases (i.e. more “quantitative easing”).

We continue to be mystified by the logic used by the Fed to justify QE (i.e. how will the ‘wealth effect’ get overleveraged consumers to buy, buy, buy?…how will the ‘wealth effect’ get ever cautious large businesses to invest, invest, invest when their customers are cautious?…how will the ‘wealth effect’ get banks with more hidden losses to lend, lend, lend to consumers, let alone, non-publicly held businesses?…and how can buying US Treasuries both lower rates AND increase inflation expectations?).

But, let’s assume that QE will do more than simply push up securities prices and continue to help the ongoing repair of the balance sheets of large banks to whom the Federal Reserve most definitely defers, if not serves and protects (like the slogan of the Los Angeles Police Department).

Let’s return to what started this economic crisis and dislocation, The Greatest Deleveraging in the History of the World. The Fed (and the US Treasury through government fiscal policy) has met this major cause with The Greatest Releveraging in the History of the World. While all the media churns over the size of the deficit and debt (fiscal policy leverage), let’s take a look at leverage at the Fed.

What if you were running a financial institution with 56 million in capital supporting 2.3 billion in assets? Would the regulators close you down? With a capital ratio, just a little better than 2%, it would only be a matter of time, probably measured by the hands of the clock.

But, what if that same institution decided to grow to 3 billion in assets. Make that capital ratio less than 2% and you can just picture that ‘cease and desist’ order from the regulators.

Now multiple those numbers by 1,000 and you get a look at what the Federal Reserve System’s balance sheet looks like before and after the announced round of Treasury purchases. And that doesn’t take into account the accounting basis (fair value, cost, etc) for those assets and liabilities.

When will the markets (and the public) think that this leverage is too much? Of course, the Fed could easily ask Congress for a capital contribution, but at what point will the markets (and the public) realize that this is all a continuance of moving money from the ‘left pocket to the right pocket’…and not a true economic transaction?

Of course, we may not appreciate Professor Bernanke’s monetary experiment, but we all are subjects within it. And, that means that we must carefully look at its impacts.

That starts with performing a sensitivity analysis of how low and lower interest rates will impact your company’s investment income over the next few years. Do not be surprised that, especially for long tail lines of business, lower rates will severely hurt income as the impact of compounding interest at lower rates, takes its toll at an increasing rate as durations lengthen.

Of course, the flip side of this is that QE2 ignites higher rates., with the prospect for higher investment income. But, if this is due to inflation, it may negatively impact reserve calculations for many lines of business.

Financial markets will eventually catch up with the reality of the Fed’s overlevered situation and require changes in their modus operandi.

When that happens (as the markets have pushed some Euro economies), change will be swift. Rates and spreads may rise to unjustified levels temporarily, and, perhaps the US may not be seen as the ‘safe haven’ of the world’s reserve currency any longer. Thinking ‘outside the box’ and understanding how these macro dvelopments may impact your company’s investment philosophy are vital at this stage in the battle between private deleveraging and public releveraging.