Thursday, January 12, 2012

The world's biggest hedge fund

John Cochrane stole the words out of my mouth—I was planning to write something very similar, but he beat me to it:

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!

He is absolutely right, and I'll take this opportunity to elaborate. The Fed borrows money by paying for what it buys with bank reserves. The current interest rate on bank reserves is 0.25%, and the Fed decides what that interest rate will be. Imagine having a hedge fund that had virtually no limit on how much it could buy, was not subject to any regulatory scrutiny, and also had the power to determine the rate at which it borrowed money? What a deal. And by the way, this most fantastic hedge fund we call the Fed has already bought close to $3 trillion worth of assets, three times as much as it held in early September 2008. What could possibly go wrong? Unfortunately for those of us in the private sector, the Fed's profits come at our expense, and to the benefit of our government (the Fed hands over its profits to Treasury). And should the Fed end up on the wrong side of rising interest rates, the Fed's losses will be paid for with our taxes and via higher inflation.

At the very least, this is one reason that the world's investors are willing to pay $1700/oz. for gold, an amount that is more than three times the average inflation-adjusted cost of gold over the last century.

I'm not saying that a disaster awaits us, only that there are plenty of reasons these days for investors to be worried about what's going on. And that's why so many things are so cheap.


John said...

"the Fed's profits come at our expense, and to the benefit of our government."

I don't get that. Who in the government is getting rich off of this practice? How is the Fed's "profit" at our expense?

What happens to the Fed's "profit?" Does it go into the Treasury? I doubt it goes into Bernanke's Swiss bank account.

The Bank of North Dakota is the only state owned bank in the U.S. It makes very conservative investments and it earns money for the state of ND. The residents of ND prefer that to more taxes.

Would you say ND's bank profits at the residents of ND's expense?

Squire said...

I can't answer to John but I recommend John Cochrane. I have learned a lot from reading his longer papers. I hope his blog is as stimulating.

I didn't know he had started a blog. Thanks for the information.

Squire said...

Here is my comment on Cochrane's blog post "The World's Biggest Hegde Fund".

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

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.

Public Library said...

I am willing to say it, the Fed is setting us up for disaster. This is becoming a self fulfilling prophecy of sorts.

Benjamin Cole said...

It is sad to see America's right-wing, usually the more sensible group when it comes to economic policy, become a rabble of gold nuts and Fed bashers.

The Fed has been passively tightening the money supply, a prime contributor to the Great Recession.

The Fed should have been far more aggressive, and should be far more aggressive, in stimulating the economy.

We are mimicking Japan in our fiscal and monetary policies.

Bernanke went to Japan on an advisory mission before he become Fed chairman. The joke is, that it was the Bank of Japan advising Bernanke, not vice versa.

Cochrane is justifiably worried about large federal deficits. Why he conflates federal deficits with monetary policy is beyond me.

Public Library said...

All varieties of (government) interference with the market phenomena not only fail to achieve the ends aimed at by their authors and supporters, but bring about a state of affairs which — from the point of view of the authors' and advocates' valuations — is less desirable than the previous state of affairs which they were designed to alter.

If one wants to correct their manifest unsuitableness and preposterousness by supplementing the first acts of intervention with more and more of such acts, one must go farther and farther until the market economy has been entirely destroyed and socialism has been substituted for it. (Ludwig von Mises, Human Action, p. 854)

William said...

Summaries of the 2006 Federal Reserve minutes have made interesting reading:

"Inside the Fed in 2006: A Coming Crisis, and Banter"

ronrasch said...

Marc Faber believes the Fed is very destructive and that in a credit dependent economy will always work to keep interest rates below the rate of inflation (a hidden tax on savers) He explains is perspective in this Ludwig Von Mises prsentation