Minyan Mailbag: The Fed's Limitations

Mr. Practical,

I know that the "Federal Reserve" is a conglomeration of the 12 Fed regional members, which are technically private entities owned by member banks. So when the Fed does things like accept ABCP and MBS as collateral, who takes the risk on those assets while they are on the Fed's balance sheet? The Wikipedia entry on the Federal Reserve says the following:

"The 12 regional Federal Reserve Banks (not to be confused with the 'member banks'), which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations-possibly leading to some confusion about 'ownership.' For example, the Reserve Banks issue shares of stock to 'member banks.' However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock by a 'member bank' is, by law, a condition of membership in the system. The stock may not be sold or traded or pledged as security for a loan; dividends are, by law, limited to 6% per year."

As an investment, this would seem like a pretty lousy one, with upside being just the 6% annual dividend. Does this mean the downside is capped as well? Knowing who's ultimately liable for losses the Fed might sustain is crucial in understanding what Bernanke's next move might be.

-Minyan C


MC,

This is a great point that I alluded to in previous thoughts.

Ultimately, the Fed is not a bottomless pit there for the discretions of politicians eager to please constituents (bail them out). The Fed does have a monopoly on money, which provides a nice steady income to its shareholders as monopolies usually do. These shareholders know who butters their bread, but when push comes to shove, they won't feed their bread to the birds.

Bernanke cannot "drop dollars from helicoptors" to the "nth" degree because that would plummet the Fed's balance sheet into ruins. He is already stretching the rules to the breaking point (allowing less than pristine collateral to lend more credit to banks, allowing increased lending with that collateral from banks to their non-banking entities like brokerage, etc., etc.).

There is a limit and that limit is fast approaching.

-Mr. Practical