Did Something Blow A Hole In The Fed’s Balance Sheet? – Dave Kranzler

[Note:  A reader alerted me to this – LINK – which explains the $19 billion drop in Capital Surplus.  Congress passed a law requiring all surplus capital at the Fed in excess of $10 billion to be transferred to the Treasury as part of the Highway Bill passed in early December.  But does not change the thesis for the banking system underlying the analysis below:  the banking system is starting to collapse again from billions in defaulting loans – loans that banks refuse to write down in value, just like they refused to mark down the value of the collapsing mortgage derivatives trusts in 2008 per “The Big Short.”  It also calls into question the credibility of a Federal Reserve that is allowed and enabled to operate with just .8%  book capital – $39 billion in book capital against $4.442 trillion in liabilities covered by just $4.482 trillion in “assets.”  Finally, it calls into question the legitimacy of a Federal Government that continues to pass legislation for spending programs for which it has an increasingly diminished ability to fund. The analysis below is a snapshot of the collapsing U.S. and financial, economic and political system.]

TND Guest Contributor:  Dave Kranzler

The basis for this analysis is a video published today by Mike Maloney titled,  Is A Financial Crisis Being Covered Up?  My hats off to Mike for finding this data from the Fed because I would not have  otherwise been looking for it.  To help think about the analysis below, keep in mind that the Fed’s balance sheet is an aggregation of all of the Regional Fed balance sheets, which themselves are an aggregation of the banks that are members of each Regional Fed.   (Click on image to enlarge)

On December 23, 2015 the Federal Reserve’s Capital Account plunged by 65% – $19 billion – when the Surplus Capital Account dropped by that amount.  The Capital Account (CA) represents the capital required to be paid in (“Paid-In Capital) to the Fed when a bank becomes a member of the Federal Reserve system. Think of the CA as the “book value” of the Fed – assets minus liabilities.   The Surplus Capital represents “retained earnings” and the Fed is required to maintain Surplus Capital equal to 100% of Paid-In Capital. This requirement is set by the Board of Governors.  Currently, Fed interest earnings in excess of the required Surplus Capital and net of expenses is then transferred to the Treasury in the form of a dividend.

The 65% plunge in the Fed’s Total Capital Account, accounted for by the $19.4 billion drop in Surplus Capital, took the Surplus Capital account down to only 25% of Paid-In Capital (Total Capital minus Surplus Capital = Paid-In Capital).  This points to a large scale financial crisis that had to be addressed by allowing some of the Fed member banks to withdraw an amount of Surplus Capital well in excess of the amount required by the Fed’s Board of Governors.  Perhaps that might explain the Fed’s unscheduled “expedited, closed meeting” that took place on November 23.

Per the Financial Accounting Manual for the Federal Reserve Banks,  the primary purpose of  Surplus Capital is to provide a buffer against Paid-In Capital in the event of losses.  And there’s the rub.  Without having the benefit of even a modicum of Fed transparency, I would suggest that the $19 billion removed from the Surplus Capital account at the Fed was used to address collapsing energy-related loans (assets) sitting on the balance sheet of some of the big regional banks.  On the assumption that these assets fall within the 10% reserve ratio requirement, it would suggest that some or several regional banks – and possibly one or two of the Too Big To Fail banks – have sustained at least $190 billion in losses in their energy-related loans.  Or they are getting ready to take write-downs of that magnitude.

Interestingly, as I was getting ready to write up this analysis, a colleague with an energy industry contact in Canada called to tell me that he had just heard that CIBC is getting ready announce a big round of job cuts related to its energy banking business.  The insider at CIBC also said that the big hits to the Canadian banking system are still coming.

I would suggest that this information can also be applied to domestic U.S. banks as well. We already know that the Dallas Fed has instructed its member banks to refrain from marking to market their energy loans and from pulling the plug on energy company borrowers who are in serious delinquency or technical default.   We also know that Wells Fargo is somewhat admitting to sitting on an energy loan problem and that Citibank has an even bigger problem to which it is not admitting:  Wells Fargo Bad, But Citi Is Worse.

It’s been estimated that funded (i.e. junk bonds + bank loans + funded revolver debt) is probably in the $500-750 billion area.  Total including unfunded is over $1 trillion. More ominously, we have no possible way of knowing the size of the  OTC derivative / credit default exposure connected to that $1 trillion.   But we can safely say that it’s likely to be multiples in size of the actual debt in “nominal” amount, although every bank out there will claim to be hedged and thus the “net” is a small fraction of nominal.  I would suggest that “net” becomes “nominal” when counter-parties begin to default.  Just ask AIG and Goldman Sachs.

Given that there has never been a drop in the Fed’s Surplus Capital even remotely close to the 65% plunge that occurred the week of December 23, that sudden plunge in Surplus Capital at the Fed is somewhat shocking.  But,  given the probability that it is being used as an attempt to douse the lit fuse of a massive energy-related financial nuclear bomb in the form of defaulted energy loans and related derivatives, that drop in Fed capital is horrifying.

The BKX bank stock index has dropped 18% since December 23 vs. 7.5% for the S&P 500 in the same time period.  While all eyes seem to be fixated on Deutsche Bank’s stock, it would seem to me that we should be focused on the financial meltdown occurring behind the Fed’s “curtain” that is clearly going on in the U.S. banking system based on the sudden plunge both in the credit quality of the Fed’s balance sheet and the recent cliff-dive in bank stocks.  

The U.S. financial system is collapsing.  This is evidenced by the extreme recent volatility in the S&P 500, as the Fed fights the inevitable stock market collapse, and in the recent run-up in the price of gold and silver.  As a final thought to this analysis, I would suggest the possibility that the fraudulent silver price fix on the LBMA last week was a last gasp attempt by the big bullion banks to grab as much physical silver as they can, as cheaply as possible, before the price of gold and silver are reset by the market.  How else can you explain the 40% move higher in the HUI gold mining stock index since January 19?

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About Dave Kranzler:

 I spent many years working in various analytic jobs and trading on Wall Street. For nine of those years, I traded junk bonds for Bankers Trust. I have an MBA from the University of Chicago, with a concentration in accounting and finance. My goal is to help people understand and analyze what is really going on in our financial system and economy. You can follow my work and contact me via my website Investment Research Dynamics.  Occasionally, I publish on Seeking Alpha too. As a co-founder and principal of Golden Returns Capital, LLC Mr. Kranzler co-manages the Precious Metals Opportunity Fund, a metals and mining stock investment fund.

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