Posted by: Dr Pano Kroko Churchill | September 17, 2015

Sovereign Debt Is Just Another Asset Class to Go Boom in the Night….

Seven years ago on September 15, 2008, one of the oldest investment banks in America filed for bankruptcy.

Lehman Brothers was started by a Christian family of fiscally smart Entrepreneurs who had recently migrated to the United States from old Europe, around the mid-1800s. At that time Europe was going through a severe Economic crisis brought about by flagrant disregard of economic principles by the various central European governments… who blossomed after the end of the Napoleonic wars, and the death of Napoleon himself in 1821.

In 1837 Queen Victoria came to the throne in England, Yet in the rest of Europe there was no stability to be found anywhere.

Revolutionary movements in Europe fought for independence from the various authoritarian imperial powers and the crumbling AustroHungarian empire was the most fiscally irresponsible followed closely by the Ottoman empire in their pursuit of destroying their Treasury through spending for their militaries and foreign campaign adventures. The weaknesses of the old European empires were exploited by the independence movements and the most resolute of them vied to create new countries. Bavaria became a republic in 1818.

It was at that time that the Balkans erupted in revolts against their imperial masters and thus new nations were born like Serbia and Greece amongst others after 1821.

In 1837 Hungary split from Austria and this signals the end of the AustroHungarian empire because of financial collapse reasons.

War was brooding all over… since it always follows financial ruin closely.

It was certainly a good time to leave Europe if you were far sighted and had a family to feed, grow, and to get the kids educated.

So the Lehman brothers left the old Austrohungarian empire and their ancestral roots behind and struck for the new World.

Once they arrived in the shores of America, they headed inland and settled in the South. They started out in business as many other merchant pioneers, with a simple general store in Montgomery, Alabama. Yet soon enough they shifted gears, and turned their attention to King Cotton. This being the abundant cotton grown in the fertile lands of the Mississippi that led the general trade of the area.

Their early cotton gin machines were well engineered and soon enough the Lehman Bros, grew in stature and gained some financial muscle in the cotton industry. In time they grew to become one of the dominant cotton traders in the country, exporting cotton and shipping goods all over. Business was good and their strong box filled with cash that they often lend to others at a small interest.

Selective of their borrowers, they managed to preserve their capital, and to grow their wealth. This led them to get into full time investment banking, by taking stakes in other folks’ enterprises. Smart and careful of observing patterns and the trends of Commerce — they pivoted again going upstream into full fledged finance. Soon enough they became dominant in that trade as well.

Eventually they became one of the largest financial firms in the country.

In a few decades they were one of the few dominant Financial players in the world…

Lehman Brothers grew out of trade, commerce, and wide banking, into Investment Banking practice and Arbitrage.

They became known as the Investment Banker to the world. And rightly so because the Lehman Brothers firm was so thoroughly globally networked, and invested in banking and financial relationships, deep into the fabric of the World’s Economic System, and their inputs were so large — that when they went bust seven years ago, they nearly dragged down the entire world’s financial system with them.

And that’s when the Federal Reserve and the US government stepped in with trillion dollar taxpayer-funded bailouts, interest rate cuts, and quantitative easing. The FED put out the fires and rebuilt the Economy and the Banking System along everything else that was burning up. That act alone took a lot of guts and plenty of financial “water” to put out the fires…

Yet back then it was a different world. Today the FED is the big gorilla in the room and we only have the QE to remind us of the bullet we dodged and some countries have had their whole Sovereign debt asset class down in the shitter. Look at the European periphery like Greece, Italy & Spain, look at Russia, and maybe Japan and China… too.

Still back in the time of the Lehman Bros collapse days, the US government’s total debt was ‘only’ $9.6 trillion. Today it’s over $18 trillion… and once they raise the debt ceiling, which is inevitable, the debt will rise overnight to over $19 trillion — that is double in seven years.

The FED in 2008 was also quite different.

The entirety of its balance sheet was just $924 billion. And the total of its reserves and capital amounted to $40 billion, roughly 4.3% of its total assets.

Today the Fed’s balance sheet has ballooned to $4.5 trillion, nearly 5x as large. Yet its total capital has collapsed to just 1.3% of total assets. And falling.

This is a hugely important figure– think of it like the Fed’s “net worth”.

The Fed, just like anyone else, needs to have a positive net worth, i.e. the value of the Fed’s assets needs to exceed their liabilities.

In the Fed’s case, its liabilities are all the trillions of dollars in currency units that they’ve created, known as ‘Federal Reserve Notes’.

And its assets are things like US government bonds.

Over the last several years during its multiple quantitative easing programs, the Fed has essentially created trillions of Federal Reserve Notes (i.e. ‘money’) and used those funds to buy US government bonds.

In conjuring all that new money out of thin air, they created about $3.5 trillion worth of liabilities, which were offset by the $3.5 trillion worth of bonds they purchased.

In total, the Fed’s “net worth” hardly budged. And as a percentage of their total assets, their net worth really tanked.

This is known as leverage. And by any definition, the Fed is highly, dangerously leveraged.

In fact, when Lehman Brothers went under in 2008, its total capital was 3% of its balance sheet. The Fed’s is less than half of that.

Now, today the Fed is meeting to discuss the question– to raise, or not to raise interest rates?

And when I looked at the numbers, I realized something interesting is about to happen.

The universal law of bond markets is quite simple: bond prices and interest rates move inversely to one another.

In other words, when interest rates go up, bond prices go down.

Think about it like this: let’s say the prevailing interest rate in the marketplace is 5%, and I have a bond that pays 5%.

Right now if I wanted to sell it, my bond is worth $100.

But then tomorrow morning the Fed decides to raise interest rates from 5% to 10%. Yet my bond still pays 5%. Is it still worth $100?

No chance! Why would anyone pay me the same price for a 5% bond, when now they can go down the street and get 10%?

The only way I can sell my bond is if I drastically slash the price.

That’s what happens when interest rates go up– the value of existing bonds goes down.

Now think about the Fed. They’re sitting on $4.5 TRILLION worth of existing bonds, most of which they purchased when interest rates were basically zero.

So what happens if the Fed raises rates? The market value of their entire bond portfolio will fall.

And given the razor-thin capital the Fed has in reserve, they can only afford a tiny 1.3% loss on their bond portfolio before they too become insolvent.

So the grand irony of today’s Fed meeting is that by raising interest rates, the Federal Reserve will be creating its own insolvency.

And that, ladies and gentlemen, pretty much sums up the absurdity of our financial system.

With a balance sheet so over-leveraged, the Fed effectively has no policy tools left to fight a major crisis.

They have no room to lower interest rates (they’re already at zero!) and if they raise interest rates, the Fed becomes insolvent.

It’s amazing.

And what’s even more amazing is that the US is being viewed as the ‘safe haven’ right now.

In many instances the dollar has hit ALL-TIME highs against other currencies in this misguided view that the US is the safe place to be right now.

The actual data, on the other hand, tells a completely different story.

The US isn’t the safe haven. The Fed isn’t the safe haven.

But looking around the world, Japan isn’t a safe haven either.

China sure as hell isn’t a safe haven. Europe isn’t a safe haven. And even Switzerland has negative interest rates.

We may be approaching a bifurcation point very rapidly where if the world realizes that the US dollar is in the same boat, there will be absolutely no safety anywhere in the traditional financial system.

Yours,
Dr Kroko

PS:

And of course the Fed is sitting on $4.5 TRILLION worth of existing bonds, and with a balance sheet so over-leveraged, the Fed effectively has not many active policy tools left to fight a major crisis.

But it has the marginal profits of it’s QE to spend…

Yet since they have no room to lower interest rates, and they presumably know that if they raise interest rates, the Fed itself becomes insolvent — we don’t expect much in the way of action or reaction besides continued QE as warranted.

So all is quiet on the FED front…

And that should remain that way.

Now more good news are expected as they are arriving daily. Our good Fortune holds…

Our deficit is getting really down to zero and maybe we can get a handle on our debt too now that it has scaled the 17,824,071,380,733.82 mark of September 2014.

Did you know you can actually look up the figures of the Treasury itself?

Indeed here it is: http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt_histo5.htm

This is what we have to deal with, because our Freedom depends on having a strong balance sheet and that still remains our number one priority.

It’s really basic: Produce more, export more, and borrow less.

Freedom from Debt is Liberty itself.


Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: