Gold News

The Fed is NOT a Hedge Fund

The Federal Reserve turned over $79.6 billion in "profit" to the US Treasury last year. That's given some folk the wrong idea...

IN A RECENT New York Times piece, journalist Steven M. Davidoff called the Federal Reserve, "the most successful hedge fund around."

After reading the article, we concluded that Mr. Davidoff is the most creative financial writer around, writes Eric Fry for the Daily Reckoning.

As such, Mr. Davidoff may be the perfect apologist for today's dysfunctional monetary "system." Certainly, he possesses the cerebral alacrity to dodge whatever cold, hard facts may be standing in the way of a good story.

"I call the Fed a hedge fund," Davidoff cheerily explains, "because it is operating like one, leveraging its balance sheet to earn huge profits."

We might have been able to embrace Davidoff's analysis were it not for one nettlesome fact: the Fed is absolutely nothing like a hedge fund. The Fed is, instead, more like a crime syndicate — a racketeer that relies on coercion, deception and outright larceny.

But before explaining The Daily Reckoning's official metaphor for the Fed, let's return to Davidoff's metaphor and "analysis." Says Davidoff:

Last year, the central bank turned over $76.9 billion in profit to the federal government, slightly down from $79.3 billion it provided in 2010.

The Fed made this money in interest on a nearly $3 trillion portfolio of securities. This enormous holding was built up largely in the wake of the financial crisis as the Fed bought these securities through two rounds of quantitative easing.

I call the Fed a hedge fund because it is operating like one, leveraging its balance sheet to earn huge profits. The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn't have any borrowing costs, meaning yet more profits.

Remarkably, the Fed's profits are also an afterthought. The Fed is trying to stabilize and increase the United States economy in the wake of the financial crisis, and its profits are a nice byproduct.

Still, these earnings blow away any other hedge fund profits.

Hmmm...where to begin our autopsy of this fatally flawed analysis?

Let's begin at the end with those earnings that "blow away any other hedge fund profits."

If Davidoff is referring only to the Fed's $79.3 billion "earnings," without any regard for the denominator that produced those earnings, he is absolutely correct. No other hedge fund in the world came close to earning $79.3 billion in 2011, primarily because no other hedge fund in the world runs a $3 trillion portfolio. But obviously, the absolute number tells us nothing about the genius — or lack thereof — behind the Fed's investment activities.

To get a feel for that, let's now insert a denominator and calculate a return. Based on the $3 trillion portfolio that Davidoff cites in his column, the Fed produced a 2.6% return. That kind of number would not pop any year-end champagne corks in any hedge fund office in the land. [Editor's note: In reality, the Fed's balance sheet averaged about $2.75 trillion during 2011, not $3 trillion. But since $3 trillion is the number Davidoff uses, we'll use it also].

But maybe Davidoff had a different return calculation in mind when he dubbed the Fed "the most successful hedge fund around." Maybe he was thinking the denominator ought to be zero instead of $3 trillion, since, as he observes, the Fed "effectively creates its own money." In this scenario the Fed's investment activities would have produced a mind-boggling return of "infinity percent."

Davidoff is absolutely right; no hedge fund can do that.

Or maybe Davidoff was thinking of a denominator somewhere between zero and $3 trillion. Maybe he had $676 million in mind, which is the actual amount of money the Fed spent last year printing new Dollar bills. In this scenario, the Fed's result would have been a spectacular 117.3%. That's not quite infinity percent, but it's not bad.

Unfortunately, there's another problem with Davidoff's analysis; the numerator is as much a mystery as the denominator. In other words, the Fed's theoretical $79.3 billion return is a bogus Beardstown Ladies kind of number since it does not account for marking all the Fed's securities to market. Without marking its vast $3 trillion portfolio to market, the actual results of the Fed's investment activities are unknowable.

Perhaps the Fed's hodgepodge of Treasury bonds, mortgage-backed securities, currency swaps and other financial jetsam increased in value during 2011, in which case the total return would have been higher than 2.6%. Or perhaps these holdings decreased in value, in which case the total return would have been lower than 2.6% — maybe even negative.

No one knows. (Or if they know, they aren't saying).

Net-net, Davidoff's analysis, expressed as a mathematical equation, would be greater than or equal to idiotic. That said, as a fellow journalist, we sympathize with Mr. Davidoff. We, too, have written things that should never have survived the copy-editing process. But when we have, we have heard about it from readers…just as Mr. Davidoff heard about it from many of the bloggers on Yahoo! Finance who responded to his column:

Kaos from Plainfield, Connecticut wrote:

Anything done by the NY Times is fire starter material.

Greg from Indianapolis wrote:

"The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn't have any borrowing costs"

Yeah…that is kind of an advantage…

RJ Wrote:

So the Fed made $76.9 billion from interest on US government debt, then turned that over to the Treasury Department?

Wait, what???

JR wrote:

Maybe this year [the Fed] will print a trillion Dollars, turn it over to the Treasury, and this writer can say, "Look, a government operation made a trillion Dollars while the idiots in the private sector flounder." The New York Times is a disgrace.

Mark from Tulsa, Oklahoma wrote:

My 6-year old could make money if he could print Dollar bills at will.

While we are sympathetic with these critiques, we can't really be upset with Mr. Davidoff for producing his obsequious homage to the Federal Reserve, anymore than we can be upset with a puppy for peeing on the side of a brand-new flat-screen TV. To the puppy, the TV looks just like a fire hydrant. And to Davidoff, by his own admission, the Fed looks just like a hedge fund.

But it isn't. The Fed is a crime syndicate that relies on deception, coercion and grand larceny. It is a racketeer.

"Several forms of racket exist," Wikipedia explains. "The best-known is the protection racket, in which criminals demand money from businesses in exchange for the service of 'protection' against crimes that the racketeers themselves instigate. Traditionally, the word racket is used to describe a business (or syndicate)…that it is engaged in the sale of a solution to a problem that the institution itself creates or perpetuates, with the specific intent to engender continual patronage."

'Nuff said!

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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles
 

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