Recently, I read an op-ed piece scribed by Senator Rand Paul on the need to audit the Federal Reserve Bank. Paul argued that the Fed's financial position has become highly precarious.
Imagine an institution operating at a leverage level of 77x. Certainly, this would be disconcerting, as our own central bank could become insolvent, if it isn't already. Awash in mortgage backed securities, treasuries and federal agency debt, is it possible that we have built a house of cards, and might we be on the verge of a collapse in our banking system? Sen. Paul will tell you that a small hiccup could wipe out the base capital of the institution that provides the backdrop to our entire banking industry. Isn’t this the reason governments - ours, and more broadly, those across the globe, have adopted legislation like Dodd-Frank and Basel III?
My retort: the financial performance of the Federal Reserve ranks at the top of the banking industry, and it is unfortunate that those who comment on its financial position do not realize that the term “financial statements” is indeed a plural, not a singular. In other words, looking at the balance sheet alone provides a "point in time" perspective, rather than reviewing the complement of statements - i.e., income statement, statement of changes, as well as the balance sheet. And to Senator Paul, the mortgage backed securities portfolio, amounting to $1.7 trillion, are actually assets, not liabilities.
Selective Data on the Fed
Consider the first ten months of fiscal year 2014. True, the balance sheet as of October 2014 carries a Capital Account of $56 bn and Liabilities of over $4.4 tn...seemingly, a proverbial house of cards. But spend a bit of time on the Income Statement - generally a better indication of the general and ongoing health of the institution.
For the ten months ending in October, the Fed earned income of nearly $77 bn. Based on certain metrics of the banking industry, this would translate into an ROA (return on assets) of 1.70% and a ROE (return on equity) of 136%. Think of a bank in the US or globally that can perform like this. Within the US, the average ROA is 1.00%, and globally, just about 0.80%. With the exception of certain money center banks, e.g., Bank of America Corp. (BAC) and Wells Fargo & Co. (WFC) , few US banks even scare the double digit level in terms of ROE. Further, the ROA in UK banks averages 0.20%, and other Central Banks are equally anemic.
The issue with our Federal Reserve is that it pays out its income to the “nth” degree. Of the $77 bn it earned in ten months, it remitted 75 bn to the Treasury Department to support the budget, and 1.2 bn paid out in dividends. So think about any company, financial or otherwise, having a payout ratio of 99%. That is a reason for concern, as few companies could grow either operationally or in times of growth (read balance sheet expansion), without having the appropriate capital base. So, even with well-above market performance, and I would submit stellar performance by not reading the full book, rather, just the abstract on the back cover, wrong observations and conclusions are drawn. And the assets/investments held by the Fed are largely government guaranteed, or direct sovereign obligations.
If those in power want to take action, then allow the Fed to retain its earnings. In less than a year, it would more than double its capital account, reducing current leverage by 70%.
As Congresswomen Pelosi indicated in her now-infamous quote about Obamacare, namely that “we need to pass the bill to see what’s in it,” I subscribe to having those that can read the financial statements, in its full and complete context, be the ones to opine.
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