Can you think of a $1.3 trillion bank that is levered 80 to 1?

It's the Federal Reserve Bank of New York. This is where the Federal Reserve System takes its principal financial risks, and it does so at remarkable leverage. To support its $1.3 trillion of assets at Dec. 30, the New York Fed has equity of $16 billion. Expressing its 80-to-1 leverage the other way around, its capital ratio is a mere 1.3%.

Consider the $405 billion of mortgage securities held by the New York Fed, along with the $66 billion of complex securities it took from Bear Stearns and AIG, the $26 billion of preferred stock in AIG bailout vehicles and the $60 billion of agency debt mostly issued by the insolvent Fannie Mae and Freddie Mac, totaling $557 billion. It would not take much of a depreciation of these assets, indeed less than 3%, to erase the $16 billion in capital.

So if you look at the New York Fed as a bank, you might well conclude it is undercapitalized.

But is it fair to view a central bank as a bank? Well, it has $877 billion of deposits, including $582 billion from financial institutions. In one way it resembles a large savings and loan, with a heavy concentration in long-term mortgages funded with short-term deposits. It does issue currency, which regular banks are not allowed to do, but issuing currency was a central function of private banks, until the Fed monopolized it.

The stock of the New York Fed is held by the banks of that Federal Reserve district. If the New York Fed experienced losses on its risk assets that impaired its capital, would the banks have to write down their stock? That would take a brave accountant! (Imagine the phone calls from Washington.) Would the Fed exercise its legal call on the banks for more capital?

An easier and prudent strategy might be for the New York Fed to build up its retained earnings to reflect the increased risk of its balance sheet. Fed banks are enormously profitable; simply cutting the dividends paid to the Treasury Department could lead to a rapid increase in retained earnings.

One might argue that it is not fair to view the New York Fed by itself, since it could be financially supported by the other 11 Fed banks. Of course, it would not like the idea that this might be necessary, and the other banks might worry about putting the capital of their own members at risk. The New York Fed has 52% of the system's assets, so the other 11 banks together are slightly smaller than it is.

In this context, let us look at the leverage of the Fed banks. They have assets of more than $2.4 trillion and equity of $56.6 billion, for a combined leverage ratio of about 43 to 1. Their capital ratio is 2.3%. Still high leverage and a small capital ratio.

The Fed banks collectively own about $1 trillion in mortgage assets, all funded short. Thus embedded in their balance sheet is the largest savings and loan in the world. In addition, they own $147 billion of agency debt, mostly of the insolvent Fannie and Freddie.

The Fed banks are unusual central banks, because they own no gold. Most central banks have gold as one component of their assets, so that the huge increase in the price of gold has augmented the value of their portfolio. But the Fed banks had their gold (they used to own a lot) taken away by the government in the 1930s. In exchange, they were given "gold certificates," which you still find on their balance sheets. But these certificates give them no right to any gold; they are merely non-interest-bearing Treasury bonds.

The question of the "dual mandate" of the Fed to address inflation and employment is under discussion. But neither of these was its original purpose.

The Fed's original purpose, as conceived by its creators in 1913, was to provide an "elastic currency," especially to intervene in financial panics. An exceptionally elastic currency has been provided with considerable elan by the 21st-century Fed: it has given rise to the highly interesting balance sheets we have been considering.

Another purpose of the Fed was to maintain a stable currency. This has been transformed into a goal of maintaining a stable rate of depreciation of the currency at something like 2% a year. This means with a life expectancy of 83 years, the average person's prices will rise about five times and the dollar's buying power will depreciate by about 80%.

The Fed is also a major financial regulator. After each financial bust, including the latest one, the Fed's authority and prestige are expanded regardless of what mistakes it has made. Even more important, as Charles Goodhart discussed in "The Evolution of Central Banks" (1985), the Fed, like all central banks, serves as the Manager of the Banking Club. A further Fed function is to be a hugely profitable business for the government, since the shareholders get only a tiny slice of the profits, and the Treasury gets the rest.

Yes, the Fed banks are all these things, but they also are banks. They cannot be understood without considering that.

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