When Will the Fed Exhale?

Stephen King’s story The Green Mile centers around a mysterious giant of a man who has the power to heal, John Coffey. His method is to place his mouth over the mouth of the sick and suck out the gnat-like cloud of disease into his own lungs. There is just one problem. He has to let it out.

During the 2008 financial crisis, the Fed stepped in and “healed” the economy, sucking up toxic assets and heaven knows what else in order to give us the appearance that everything was OK. Like Coffey, they can only hold it in for so long.

What is this ingested disease doing to the Feds insides? As one writer says:

The Fed’s entire balance sheet totaled around $800 billion before the 2008 crash, nearly all of it Treasuries. Now the Fed holds more than double that amount in mortgage derivatives alone, junk that the banks needed to clear off their own balance sheets.

Translation: Our lender of last resort has become the same kind of over-leveraged monstrosity that caused the crisis in the first place. But wait, there’s more:

Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30-to-1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51-to-1! If the value of their portfolio were to fall by just 2%, the Fed itself would be wiped out.

I am not the nervous type, but I think Euro Pacific Capital’s Michael Pento, author of the above, has just succeeded in giving me the shivers.

John Coffey was a man tormented by his sensitivity to evil in the world. The Fed can hardly make that moral claim, but the parallels are instructive. By taking on the disease of dozens of badly-behaving banks, it now sits and waits for the chance to exhale. When it does, where will the disease land?

About Terry Noel

I am an Associate Professor of Management and Quantitative Methods at Illinois State University. My specialty is entrepreneurship.
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