So We Have Been Living Under a Royal Bloodline....

Geni.com is out today with a genealogy of George Washington and how every president, with the exception of Gerald Ford who's genealogy has not been added yet, since has been related to him in some sort of manner.  Apparently Barack Obama is Washington's 9th cousin 6 times removed.  Who'd a thought?

Speaking of monarchy, about a month ago the Federal Reserve announced some new accounting procedure that would supposedly make its finances more "transparent."  The use of the word transparent by the Fed should be regarded as an instant red flag.  At the time, many were reporting that this new accounting trick would make it virtually impossible for the Fed to become insolvent from an accounting point of view.

Today on Mises Daily, Robert P. Murphy lays out in simple terms exactly what the Fed can do now to avoid insolvency:

Prior to the announcement, the immediate move would be to mark up an increase on the "Assets" side with a corresponding credit to the "Capital" (or "Shareholder Equity") items on the right-hand side. But now, the Fed is saying that when its assets appreciate, it won't credit the capital accounts. Instead, it will make the right-hand side of the balance sheet go up by entering a new liability, titled (paraphrasing) "Earnings We Need to Send to the Treasury."

...the real fun happens when the Fed suffers losses on its assets. In normal accounting, when the market value of a company's assets goes down, the firm marks down its "Assets" (left-hand side of the balance sheet) and correspondingly marks down its "Capital" by the same amount (right-hand side of the balance sheet).

The danger is that if a firm loses too much, then it might wipe out all of its capital. At that point, the firm would be insolvent, because its remaining "Assets" would be smaller than its "Liabilities." Remember the basic accounting truism:

Assets = Liabilities + Capital (or Equity)

If the company suffers such large losses that its "Capital" (or "Equity") becomes negative, that is simply another way of saying that the company owes people more money (i.e., its liabilities) than it has in assets. That is the definition of insolvency, and unless the situation is rectified the firm will eventually default on its obligations and go bankrupt.

Fortunately, from the Fed's viewpoint, this tragic outcome is no longer possible for the US central bank. No matter how big the hit to its assets, the Fed will never be insolvent from an accounting standpoint. Even if the Fed's bond portfolio lost $1 trillion in an afternoon, the Fed would be fine: It would mark down its "Assets" by $1 trillion, and under its "Liabilities" it would list "negative $1 trillion owed to the Treasury." Thus the left- and right-hand sides of the balance sheet would still balance, and "Assets" would still exceed "Liabilities."

Kudos to Murphy for putting this new scheme into simple terms.  For those of us who's accounting background amounts to a 200 level college course, deciphering the Fed's ambiguous language is necessary to keep them in check.

Since I am on the subject of the Fed, James Hamilton has a decent article out today in Fortune laying out how the Fed doesn't really print money anymore, but just electronically adjusts bank's balance sheet.  This obviously isn't new, but Hamilton shows that banks earning interest on these reserves from the Fed is a phenomena that developed in 2008:

Prior to 2008, a bank could earn no interest on reserves, and could get some extra revenue by investing any excess reserves, for example, by lending the reserves overnight to another bank on the federal funds market. In that system, most banks would be actively monitoring reserve inflows and outflows in order to maximize profits. The overall level of excess reserves at the end of each day was pretty small (a tiny sliver in the above diagram), since nobody wanted to be stuck with idle reserves at the end of the day. When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.

All that changed dramatically in the fall of 2008, because (1) the Fed started paying interest on excess reserves, and (2) banks earned practically no interest on safe overnight loans. In the current system, new reserves that the Fed creates just sit there on banks' accounts with the Fed. None of these banks have the slightest desire to make cash withdrawals from these accounts, and the Fed has no intention whatever of trying to print the dollar bills associated with these huge balances in deposits with the Fed.

So basically in late 2008, the Fed propped up insolvent banks by loading their balance sheets with excess reserves.  In order to prevent the banks from lending out these reserves and causing mass inflation, the Fed now pays interest on them in order for banks to make money by holding on to them and not loaning them out into the money supply.  Hence the trillions of dollars that banks are holding on to, much to the dismay of politicians.  If only they understood the inflationary implications of letting about $2 trillion (I constantly hear that is what it is, so it may be different) flood into the economy by massive lending.