Philipp Bagus on The Insolvency of the Fed

CrownThomas's picture

Philipp Bagus wrote a paper in 2009 which explains that the Fed will go insolvent, and sans a Treasury bailout (ie: borrowing more from the Fed than it needs, just to give the Fed more collateral assets at taxpayer expense), the asset of the uncivilized may be its only hope.

This is something to keep in mind, as QE3 is now most certainly on order



Since August 15, 1971 the US dollar has been an irredeemable paper currency. Every irredeemable paper currency in history has failed. Yet, the experiment of the US dollar and the rest of the fiat paper world continues.

During the current crisis, however, financial systems all over the world are increasingly struggling, and the end of the experiment seems closer. In fact, the Federal Reserve System has used up much of its "ammunition" for monetary interventions in an attempt to keep the experiment going, lowering its target interest rate almost to zero. Other central banks are also quickly approaching the "zero limit" for interest rates.

Figure 1:
Average of World Central-Bank Interest Rates (FED, BOJ, BOE, ECB, Switzerland)

During these inflationary decades, economic structures have developed that can only survive with falling interest rates. As the world approaches a zero interest rate, it appears that finally there might be a full adaptation of the structure of production to the demands of consumers, and the experiment might come to an end.

Yet, has the Fed really "run out of ammunition"? First of all: what is the Fed shooting at? It is trying to artificially stimulate the economy with its monetary policy, thereby it is also unwittingly shooting at the value of the currency. Through its monetary policy, the Fed is trying to bail out an insolvent and illiquid banking system to maintain an unsustainable structure of production. As long as the currency is not totally destroyed, the Fed will never run out of ammunition. In order to assess the ammunition left, one should have a look at the balance sheet of the Federal Reserve — especially at the assets the Fed can still obtain. The Fed's balance sheet also gives insights on the condition or quality of the dollar.

Since the crisis broke out, the Fed has continuously weakened the quality of the dollar by weakening its balance sheet. In fact, the assets the Federal Reserve holds have deteriorated tremendously. These assets back the liability side of the balance sheet, which mainly represents the monetary base of the dollar. The assets of the Fed, thereby, hold up the value of the dollar. At the end of the day, it is these assets that the Fed can use to defend the dollar's value externally and internally. Thus, for example, it could sell its foreign exchange reserves to buy back dollars, reducing the amount of dollars outstanding. From the point of view of the buyer of the foreign exchange reserves, this transaction is a de facto redemption.

In the first stage of the crisis that lasted until September 2008, the Federal Reserve did not increase its balance sheet. Instead, the Fed changed its balance sheet's structure. These changes are very important for the value of the currency. Imagine that the Fed announces tomorrow that is has sold all its gold and has bought Zimbabwean government bonds with the revenues. The Fed would explain this move by arguing that the stability of the Zimbabwean economy would be crucial for the US economy and the welfare of mankind. This action by itself would not change the quantity of money at all, which shows that concentrating exclusively on the quantity of money is not sufficient to evaluate the condition of a currency. Qualitative issues can be even more important than mere quantities. In fact, an asset swap from gold to Zimbabwean government bonds would mean a strong deterioration of the quality of the dollar.

While this example might sound extreme, something similar happened during the first stage of the sub-prime crisis. The Fed weakened the composition of its balance sheet not in favor of the Zimbabwean economy but in favor of the US banking system. The Federal Reserve sold good assets in order to acquire bad assets. The good assets were not gold but mainly the still highly-liquid US treasury bonds in the category of "securities held outright." The bad assets were not Zimbabwean government bonds but loans given to troubled banks backed by problematic and illiquid assets. This weakened the dollar.

Figure 2:
Fed Balance-Sheet Assets (6/28/2007–1/15/2009, in $US Million)
Source: Fed (2009)

As can be seen in the chart, starting in August 2007, the lower-quality assets increased. They grew especially in the form of repurchase agreements and, later, new types of credits such as term-auction credits — through the Term Auction Facility (TAF) — starting in December 2007. As the Federal Reserve did not want to increase its balance sheet, it sterilized the increasing amount of bad assets by selling good assets to the troubled banking system. Swapping good assets for bad assets can in fact be considered a bail out of the banking system on a gigantic scale. Moreover, the Federal Reserve started lending securities (good assets) to banks in the so-called Term Securities Lending Facility (TSLF). This measure provided the banks with high-quality assets they could pledge as collateral for loans. As a consequence, the amount of securities decreased via selling and lending, as can be seen in the following chart.

Figure 3:
TSLF and SHO (1/03/2008–1/15/2009, in US$ Million)
Source: Fed (2009)

Thus, the average quality of the Federal Reserve balance sheet deteriorated in the first stage of the crisis and continues to do so as shown in the following compositional graph.

Figure 4:
Fed Balance-Sheet Assets (6/28/2007–1/15/2009, in percent)
Source: Fed (2009)

In the second stage of the crisis, which started with the Lehman bankruptcy, it became clear that the policy of merely changing the balance-sheet structure was coming to an end. The Fed was running out of Treasury bonds. Moreover, this policy did not allow for the strong liquidity boosts that the Fed deemed appropriate in this situation. Hence, the Fed started to increase its balance sheet. It no longer "sterilized" the additional loans it granted with the sale of good assets. In fact, it would not have had enough good assets left to sell. In our imaginary example, the Fed would run out of gold. It would stop selling gold and keep on buying Zimbabwean government bonds. Of course, the Fed did not buy Zimbabwean government bonds but other assets of low quality, mainly loans to an insolvent banking system. As a consequence, the sum of the balance sheet has nearly tripled since June 2007.

The increase of the balance sheet in favor of the financial system required some unconventional policies. Thus, the Fed has invented new credit programs with a tendency for longer terms, such as the aforementioned TAF. It has granted special loans to AIG and bought Bear Stearns assets that J.P. Morgan did not want. It has allowed primary dealers to borrow directly from the Federal Reserve in the Primary Dealer Credit Facility (PDCF). In addition, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) was created. This facility allows depository institutions to borrow from the Fed with collateral of asset-backed commercial paper.

Later the Fed decided to supplement the AMLF with the Commercial Paper Funding Facility (CPFF). Now unsecured commercial paper is also eligible as collateral. (Unsecured commercial paper is not backed by specific assets but only by the name of a company.)

Furthermore, the Fed has set up the Money Market Investor Funding Facility (MMIFF), which allows money market mutual funds to borrow from the Fed via special purpose vehicles. Three characteristics of these policies can be found:

  1. they contain credits of longer maturities;
  2. they contain credits of a broader range of eligible institutions backed by a broader range of assets than was the case before; and
  3. they, thereby, reduce the average quality of the Fed assets and consequently the quality of the dollar.

Despite of all these efforts, credit markets still have not returned to normal. What will the Fed do next? Interest rates are already practically at zero. However, the dollar still has value that can be exploited to keep the experiment going. Bernanke's new tool is the so-called quantitative easing. Quantitative easing is when a central bank with interest rates already near zero continues to buy assets, thus injecting reserves into the banking system. In fact, quantitative easing is a subsection of qualitative easing. Qualitative easing can be defined as the sum of the policies that weaken the quality of a currency.

But what new assets is the Fed acquiring? The Fed has already started buying the debts of Fannie Mae, Freddie Mae, and the Federal Home Loan Banks. It has also bought mortgage-backed securities issued by Fannie Mae, Ginnie Mae, and Freddie Mac. Bernanke is also considering buying other securities backed by consumer loans, credit card loans, or student loans. Long-term government debt is also on the list of assets that the Fed might buy.

In the analysis of the Fed balance sheet and the condition of the dollar, another detail is extremely important. The equity ratio in the Fed balance has fallen from about 4.5 to 2%.

Figure 5:
Fed Balance-Sheet Equity Ratio (6/28/2007–1/15/2009, in percent)

This figure implies an increase of the Fed's leverage from 22 to 50. As we have seen there are large new positions of dubious quality on the Federal Reserve balance sheet. More specifically, should only 2% of the Fed's assets go into default — or if there is a loss in value of 2% — the Fed becomes insolvent.

Only two things can save the Fed at this point. One is a bailout by the federal government. This recapitalization could be financed by taxes or by monetizing government debt in another blow to the value of the currency.

The other possibility is concealed in the hidden reserves of the Fed's gold position, which is only valued at $42.44 per troy ounce on the balance sheet. A revaluation of the gold reserves would boost the equity ratio of the Fed to 12.35%.[1]

Figure 6:
Fed Balance-Sheet Equity Ratio (6/28/2007–1/15/2009, in percent, hidden reserve included)
Source: Fed (2009)

It is ironic that in troubled times a revaluation of the "barbarous relic" could save the Fed from insolvency. Yet, this would only be an accounting measure and would not change the fundamental problems of the paper dollar. While shooting its last bullets and weakening the dollar, the Fed is outmaneuvering itself. The end of the experiment is getting closer.

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dvfco's picture

Ol Man - Great answer with the stats for failed / dissapeared / re-issued currencies.  I've always wondered the same thing and I feel a tad bit more informed knowing the answer.  Unfortunately, no matter what happened in the past, we're all fucked in the near future.  The Euro and US$ are toast, which will most certainly cause every paper currency to be recognized for the shit that it is.

Stop by you local bullion seller ever week after you get your paycheck and buy some gold and silver.  While it may be recalled by the Pres., you can still hide it in a mattress, just not in a bank.  So, buy, buy, buy - especially while gold and silver are now on sale.  It can't last much longer.

I love it when people tell me I've been singing the same song so long they don't want to hear it anymore.  The tsunami is coming, whether it's triggered by Greece, a trillion in derivatives going bad, or simply everyone taking delivery on their gold/silver contracts - the $ will be worth bupkis soon.  Just think how you'll feed your family and protect them.  Use the dollars now to get the shotgun(s) and a bunch of boxes of shells.  Then, fill the basement with 5-gallon bottles of water and lots of canned food.  

Just think - every night we'll be able to tell out kids, "we're going to have a lot of little good things for dinner tonight - and their all beans."  My dad was born 8/1929, just before the start of the first Great Depression and he heard that line ona good night.

Good Luck.  Thanks Z.H. - the only place I can read and not feel like I'm the crazy one.  I may be the crazy one, but I just don't feel that way here!

AUD's picture

Very good. It's about time ZH promoted the quality theory of money.

blueridgeviews's picture

Take step back from all your graphs.  How can a money printing entity become insolvent? Think about it.

Idiocracy's picture

We keep reading that "every irredeemable paper currency in history has failed."  I don't doubt that.  But it would be great to see a list of them.  Are we talking 10 currencies or 1,000?  Anybody seen a list?

Ol Man's picture

"According to a study of 775 present and historical currencies by, twenty percent failed through hyperinflation, 21% were destroyed by war, 12% ended by independence, 24% were monetarily reformed, and 23% are still in circulation."


AnAnonymous's picture

One could wonder if the FED put themselves in a classically admitted insolvency position, declare themselves insolvent, if the insolvency could be admitted by the rest of the crew.

The group is all in US citizenism, and one knows that US citizens can grow richer by monetizing their confession.

TheFourthStooge-ing's picture


The group is all in US citizenism, and one knows that US citizens can grow richer by monetizing their confession.

They could monetize it the Chinese citizenism way by grinding it into a powder and selling as longevity enhancement pills. This is how Chinese citizenism monetizes human fetuses and newborn human females.

Not very pleasant, but hey, monetization of everything is the Chinese citizenism five year plan.


Confundido's picture

This guy, Fagus, doesn't get it. He writes like a fucking professor. The world will hold US dollars as long as the US keeps its military coercive power. And when they don't, the world will hold someone else's fiat currency. Don't ever dream of gold.


By the way, in 15 minutes, at 3am, we have the algorithm launched, which will take us from $1,580/oz to a lower low. Good luck gold bugs!

capitallosses's picture

Thank you! Appreciate the buying opportunity, I love sales!

d2themfi's picture

good article. If the fed did re-value its gold (I am assuming to the then current spot price?) would it have a direct effect on the market spot price (other than the implication that the fed was becoming or already was insolvent)?

Fazzie's picture

The Fed was in default in absolute terms in 1973. In terms that matter the Fed will never ever ever in a trillon years even hint at a default simply by issuing ones and zeros in a computer.

  They can print money behind the most powerful military industrial complex in the world and they will do just that for the next 39 years.

  Fiat money works as long as the govt issuing the debt can just invade any dissenting countries.

 Nobody but nobody will fuck with the USA because the USA will fuck them up but good and send inflation lower in the process.

 Deficits dont matter just like draft dodger Cheney said for the USA anyway.

 Hyperinflation most likey will not happen in the face of economic weakness. Maybe an annoying 8 percent on average if you count even food and energy. Hyperinflation starts at 100 percent or so.

 As for the FEMA camps, they are for like suprise nukes from terrorists. After the Soviet collapse a lot of nukes went missing. You never know.

 9/11 was real but still a massive failure of the CIA. No one in the CIA had to answer much but thats politics.

 Running to the hills with your 30/30 and cases of beans wont work in a nuclear attack.

  A rebellion against the status quo even in the voting booth will never happen because the status quo has made it too damn lucrative to be sorry and draw a govt check. Remember the Corsican bros swinging into a room announcing a revolution to well fed potential bros in arms? Same deal here.


   Printing works every time until it dosent. When it dosent your fucked anyway.




tony bonn's picture

this article was an excellent summary and explanation of the fed's currency tricks to bailout the psychopathic frat boy banksters but it's conclusion is completely misguided - not because it is wrong but because it is fanciful.

the fed would never concede an inch to gold. the second problem is that there is no gold. was pissed away starting in the 1960s....that is why the usa is a leading purveyor of gold plated tungsten...

proLiberty's picture

The Fed and the ECB can only become insolvent in theory.  The instant they come close, they will engineer some feature or allowance that creates the necessary "assets", or the sponsoring sovereign will create the legal gyration that allows the creation of a sovereign asset that gets transfered to the central bank and poof, the insolvency will just go away.  We are after all dealing with the mirage manager for the sovereign.  Mirage upon mirage, all at the click of the mouse.  

(Create One trillion now?  Ok?  Are you sure?  OK!)


sansnobel's picture

Umm, no genius the FED can never be "insolvent" because it can always "print" more money and buy more assets.  Geez this is still ZH right?  Mark to market  Accounting for banks went out the window a long fucking time ago if memory serves.  Now the name of the game is Bailout and Mark to Fantasy.   In the bizzaro world we live in nowadays where the people just sit with awe, wonder and amazment at how our "Heroes" at the federal reserve will save the economy with their superior economic prowess and intellect, it amazes me people have not gotten the nearest weapon and converged on DC to begin the public executions of the theives behind the curtain.  Cognitive dissonence indeed.  I would even go so far as to say that the fed has brainwashed the masses into worshiping their little Tower of Babel and people think they owe their lives and fortunes in their submission to DEBT FUEDALISM.  Neo- fuedalism whatever you wanna call it.  Dumbshits really believe the economy could never run without a central bank.    Utter poppycock.  With the technology we have today it would be much easier to keep people and banks honest, if that where really the goal that is.  No the system is designed for legalized plunder by the parasite class, Bankers and politicians.  I could have more respect for a banker if they where putting their own capital at risk I suppose.  But leverage is leverage I suppose.  Borrow short and lend long as it goes I guess.  A Borrower nor a Lender be.......

lasvegaspersona's picture

The Fed  has gold gold...that is owned by the Treasury. It has been held safe for us since Roosevelt stole it from the American People in 1933.

The more I read the more I an attracted to the thoughts of FOA. He nailed it. Reading his ideas from 2001 are like reading today's newspaper. I think a lot of folks who are 'prepared' will be surprised by what is coming.

Central Bankster's picture

They wont go insolvent because, like the ECB and Greece, the Fed will be the senior most creditor and subordinate all others post facto.

Matt's picture

When the Fed runs a profit on its holdings, it credits the profits to the Treasury at the end of the fiscal year, right?

So if the Fed runs a deficit, does it send a debit to the Treasury instead?

Can the Fed rehypothecate the money that the banks have deposited there?


Elmer Fudd's picture

Is solvent or insolvent really applicable to a made-up entity like the FED?  Did its founders ever really pony up any money?

disabledvet's picture

I'm not sure i agree with this. At the time of the panic basically the Fed was "hoovering up" every paper asset on the planet. at the time it was all considered junk...and with the dollar collapsing and yields surging who could blame them? instead "yields have plummeted and the value of this debt has SOARED." (even the dollar excluding the yen has been moving higher for over a year now. The phucking YEN? hahahahah! amazing!) since the cost basis for the Fed is probably .00000000000000001 cent on the dollar and "the Fed can use the Reserve Currency of the Dollar to provide the credit to the banks" what exactly is the risk to the Fed again? Indeed....was there even any risk to the Treasury even! Amazingly "Fannie and Fred are now reporting billion dollar profits." The yields on that 2008 debt will probably never be seen again in our lifetime...let alone the principle appreciation. Indeed a good question can be raised "can the Fed even create inflation at this point?" They could "dump all the excess reserves all at once" i guess! Save for the surge in equities over this time frame however i say...amazingly..."no." Ironically "the banks now find themselves right back where they were" while the whole "globaloney economy thing" sinks like stone in the Mariana's Trench. So the Federal Government through the Ex/Im Bank, Fannie and Fred and the Pentagon "finances everything" while all the commodity folks are left "holding the bag on 2 percent growth with the greatest deleveraging in human history" to trade on. Oooooops! Sucks to be them! So NO! I am NOT TRADING GOLD OR SILVER HERE. Debt looks good but so do equities as "animal spirits" kick in and "Europe is reconquered by the Americans." (that may end up being literal i might add.) Phillip Morris, Proctor and Gamble, Johnson and Johnson, all the energy companies, the bulk of the chemical companies, aerospace, telecom and tech. did i miss anything? oh, "here's the video version":

RighteousRampage's picture

One day, many years from now, when all of the magic is gone, the government will reveal its hocus pocus finale by nationalizing the Fed, wiping the interagency balances, and starting anew.

The only keeping the flimsy facade from crumbling today is the nonsensical premise that one day the Fed will unwind its bloated balance sheet.  But the real question, if and when the Treasury's nationalization of the Fed comes to pass, will be:  will money printed (QE'd) 10 years prior be considered inflationary to the present time...    

any takers?

lolmao500's picture

If the FED is private, why do they give back all the profit they make to the treasury?

jumblies's picture

If the FED isn't private, why do they pay their shareholders a 6% dividend?

rocker's picture

I gave this the lowest rating I could for the headline. Never Read a Word of it.  WHY ???

Because the FED can print to infinity !!!   This has to be the most stupid headline on ZH to date.

The FED "can" devalue the dollar to equal Zimbabwe bucks, But, insolvent. Nope. Never.   

collon88's picture

Exactly what I thought. How can the creator of "money" ever not have enough to avoid bankruptcy?  A zero here, a zero there and like magic, its cup runneth over.  WTF Tyler, the article is nonsense!  And from 2009?  Is this some kind of test to see if ZHers are paying attention?     

Sam Clemons's picture

Same.  A private bank that doesn't have to do MTM accounting, can create its own money, and is essentially unauditable cannot become officially insolvent.  It is impossible.  

Bollixed's picture

The above article is from Feb 5, 2009...

fourchan's picture

i care not whom makes the laws...blah blah blah..

bankruptcylawyer's picture


Revaluing gold or no....the only use of a revaluation is if the fed sells off its gold hoard in exchange for more shitty assets. The fed WILL NOT sell off its hoard. It will attempt to continue leasing out gold and attemting to take whatever may be left of the treasuries gold. If there is a deseperation the fed will do whatever it needs to keep itself alive.

The cartels legal power is the biggest asset that the too big to fail banks own. Should the feds very existance be threatened by congress ( hard to imagine i know ) ------ only then would the fed sell its gold......and only in self dealing to the largest shareholders of the fed including jpmorgan citi goldman....the rats will take the gold only if they are forced to abandon ship.
World war 3 would happen sooneer than this. And by that imean the american mass mob would be sooner swayed towards mass bombing campaigns abroad than unshackling themselves from centralized bank bondage.

Shibumi2's picture

they can't revalue gold without affecting the value of official outstanding fiat, which would lead to a massive devaluation of dollar buying those who understand such things

Dead Canary's picture

Yes, but I don't own dollars. I own B-relics. How does this affect me? Me, me, me?

illyia's picture


delivered's picture

Simple logic holds here as interest rates have to rise only slightly towards more normal levels so that those wonderful UST holdings in 10 and 30 year debt will decrease in value quickly. Of course this assumes the Fed will use Mark to Market Accounting (Not!) or they use the logic "We're holding to maturity". In addition, since the Fed is stuck with current interest rates (as rising interest rates are a killer at this stage) and they basically control short-term rates and can impact long-term rates with their policies, why would an organization knowingly implement a strategy that would significantly reduce the value of their primary assets? Not going to happen so while the leverage of the Fed is absolutely insulting and even the smallest asset value adjustment would result in insolvency, I just don't see it happening as long as they exert control of the markets. You talk about being stuck between a rock and a hardplace, well the Fed is there and then some.

Of course I figure Ben is using the tried and proven strategy of simply attempting to finish his term and lay the problems on the next poor sap (from Alan to Ben, etc.). Just like the scene from the movie Traffic when Micheal Douglas was taking over the war on drugs from a general, I believe played by James Brolin. The advice was simple. Make two envelopes the first which blames the previous parties in charge for the on-going failure and the second one to give to the next party taking over. No way out of this mess and Ben knows it.

nmewn's picture

Fuck the Fed.

Our Forefathers warned us of the wicked entreaties, the gaseous unicorn fart promises of wealth without reason or value long ago.

Why is it incumbent on the rational to prove an absurdity for eternity?

AnAnonymous's picture

Did your forefathers warn you about the risks consequent to emitting principles and monetizing their dismissal right after?

nmewn's picture

"Did your forefathers warn you about the risks consequent to emitting principles and monetizing their dismissal right after?"

What principle was Mao operating under?

TheFourthStooge-ing's picture

AnAnonymous said:

Did your forefathers warn you about the risks consequent to emitting principles and monetizing their dismissal right after?

Yes. They said beware of the creeping spread of Chinese citizenism.


Zero Govt's picture

well the creeping spread of Chinese citizens is doing very well thank you... first it was take-aways in every major Western city and now it's China trading shops into the retail sector... not to mention all the other products Made in China

Commerce is the way ahead and the way to prosperity

Yet we all focus on the fucking Fed who, like the banking sector, just produce worthless paper games

Shibumi2's picture

The MADE IN CHINA phenomenon was, also, a byproduct of the FED and FED POLICIES.

I have worked extensively with the Chinese and see them for what they are. The Chinese are industrious, but are not MANUFACTURERS per-se. Not in the sense of HENRY FORD and others whose sweat and toil birthed a nation.

CHINA has their place, and so does AMERICA.

True wealth comes not from COMMERCE, the trading of goods and services, but from INNOVATION, NEW TECHNOLOGIES, and the promise of OPPORTUNITY, free of restrictive and arbitrary barriers to participation...NOT PANDERING SLAVE LABOR TO THE WORLD. THE US is the leader in these important aspects, and it is a STATE OF MIND more than a physical location. Move all the CHINESE to AMERICA and you will end up with CHINA EAST.

Likewise, move all Americans to China and you will have AMERICA WEST.



falak pema's picture

no king can be declared insolvent as long as he has the biggest army, as he can go rob his neighbour whenever he wants to. We are there. The US feels it can print to infinity and do what it likes with its fiat hegemony as it won WW2 and Cold War and now bestrides the globe on its nuked overkill. 

That is why the alternative strategy of Mao's legacy, aka Vietnam, is never to give a target to the super power. Like Ben Laden, the fish will swim amongst the people, and bite and bite, and wait for the empire to implode from within. Time is on the side of the alternative empire. They have the people and the patience. We have the Jamie Dimons of sleight of hand and fake monetization.