Wednesday, January 11, 2012

The World's Biggest Hedge Fund

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! 

Is this good or bad?

One argument for "good" was made famously by Milton Friedman. Commenting on central bank's interventions in currency markets, he pointed out that the central bank, like any trader, contributes to stability of asset prices if it makes money by trading. If you successfully buy low and sell high, then your actions raise prices in bad times and dampen them in good times. The usual practice of defending currencies and then giving in and devaluing them has the opposite effect.

By that measure, our Fed scores well so far. (I'm presuming here that price stability is desirable, which purists may quibble with, but let's not go there right now.)  On the other hand, we also know not to evaluate long-term portfolio performance with one good bet.

There is also no return without risk. Any trader who makes a superbly good return in one period is taking a risk of poor returns in the next. When (not if, when) long-term interest rates rise, the Fed will lose money on its portfolio of long-term bonds. If the economy gets worse, it will lose money on its credit risk portfolio. And so on.

Taking big portfolio risks is quite a change for the central bank. Traditionally, a central bank issues currency and reserves  and holds very short-term government or high-rated private debt. It earns a liquidity spread which it rebates to the Treasury. It does not take on substantial term or credit risk, and therefore it does not expose the Treasury to the possibility of losses.

(Some people think that central bank capital or portfolio losses don't matter. After all, it can always print money to pay its bills. That view is a fallacy. When the Fed needs to contract the money supply or raise interest, it needs assets to sell. Losses on its investment portfolio must eventually be made up by extra taxes. Benn Steil explains in more depth here and I'll come back to this issue if the comments section lights up.)

How much of a problem is the Fed's risk-taking, though?  In terms of overall debt and deficits, the Fed does not pose that much of a threat. Or, perhaps I should say, other things are worse. The Fed's balance sheet is "only" $3 trillion dollars. Even if it lost half of its assets, $1.5 trillion is one year's worth of Federal deficits,  10% of GDP, or 10% of the national debt. Losses on the Fed's portfolio are not going to bankrupt the country or send us to hyperinflation. The Treasury can sell bonds and give them to (sorry, "recapitalize") the Fed, and then raise taxes to pay off the bonds.  (That said, it would be nice to see a "stress test" on the central bank. Doctor, heal thyself.)

The real danger, then, is political, not financial. Imagine the fallout if the Treasury has to bail out the Fed to the tune of a few hundred billion dollars. The Fed would certainly lose a lot of independence.

Current thinking about monetary policy values the independence of the central bank.  An independent central bank is a way for the government to precommit ex-ante that it won't try to goose the money supply ex-post around elections. 

But the price of independence is limited authority. You cannot, in a democracy, have appointed officials with very long tenure writing checks to voters, allocating credit to specific industries, choosing winners and losers, or signing up the Treasury for trillions of dollars of tax liability.  The Fed cannot drop money from helicopters as Milton Friedman once recommended; that's called a transfer payment. The Fed can, in theory, only buy and sell safe securities of equal value. As dysfunctional as Congress and Administration may be, taxing and spending are their job, as they face the voters.

Of course, Federal Reserve actions have always had fiscal consequences. For much of history, the main role of central banks was to lower the interest rate on government debt, by making that debt more liquid.  And its "independence" has always been a relative thing as well. So as in many things, there is a sliding scale. But our Fed has certainly moved dramatically in the direction of actions with important, direct fiscal consequences. It must bear some cost of less independence as a result. We'll see what that is.

But potential portfolio losses strike me as a tip of the iceberg of actions that threaten the Fed's independence. The Fed participated in bailouts of specific companies and industries. It allocated credit to specific markets. In its expanded role as regulator it will be telling more and more banks how to run their businesses. It is now speaking more and more loudly about tax and spending policy, such as advocating mortgage bailouts. Its is setting "financial policy" more than "monetary policy."
The Fed is not likely to remain as independent in this expanded and very political role.

One thing is clear -- our monetary policy and central banking institutions are evolving fast.