The World's Biggest Hedge Fund

The world's largest hedge fund paid $79.3 billion dollars to its master copy investor final yr , equally announced to the press too reported past times the Wall Street Journal this morning.

It followed classic hedge-fund strategies. It's leveraged virtually 55 to 1 , pregnant that for every dollar of uppercase it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that coin to brand aggressive bets inward long-run authorities bonds , equally good equally strong speculative positions inward mortgage-backed securities too straight distressed lending. Lately it's been putting bigger bets on loans to Europe too currency swaps. (Balance sail here.)

The payout was genuinely conservative , equally it reflected alone the greater involvement payments earned on its portfolio of assets too realized gains , non the substantial unrealized uppercase gains it made over the final yr equally long-term bond prices rose.

Who is this miraculous fund? Why our ain Federal Reserve of course! 

Is this adept or bad?


One declaration for "good" was made famously past times Milton Friedman. Commenting on cardinal bank's interventions inward currency markets , he pointed out that the cardinal banking concern , similar whatsoever trader , contributes to stability of property prices if it makes coin past times trading. If y'all successfully purchase depression too sell high , so your actions heighten prices inward bad times too dampen them inward adept times. The commons exercise of defending currencies too so giving inward too devaluing them has the contrary effect.

By that stair out , our Fed scores good so far. (I'm presuming hither that toll stability is desirable , which purists may quibble amongst , but let's non teach at that topographic point correct now.)  On the other mitt , nosotros likewise know non to evaluate long-term portfolio surgical operation amongst ane adept bet.

There is likewise no render without risk. Any trader who makes a superbly adept render inward ane menses is taking a adventure of piteous returns inward the next. When (not if , when) long-term involvement rates rising , the Fed volition lose coin on its portfolio of long-term bonds. If the economic scheme gets worse , it volition lose coin on its credit adventure portfolio. And so on.

Taking large portfolio risks is quite a modify for the cardinal bank. Traditionally , a cardinal banking concern issues currency too reserves  too holds real short-term authorities or high-rated someone debt. It earns a liquidity spread which it rebates to the Treasury. It does non accept on substantial term or credit adventure , too thus it does non disclose the Treasury to the possibility of losses.

(Some people retrieve that cardinal banking concern uppercase or portfolio losses don't matter. After all , it tin ever impress coin to pay its bills. That sentiment is a fallacy. When the Fed needs to contract the coin render or heighten involvement , it needs assets to sell. Losses on its investment portfolio must eventually last made upwardly past times extra taxes. Benn Steil explains inward to a greater extent than depth here too I'll come upwardly dorsum to this number if the comments department lights up.)

How much of a work is the Fed's risk-taking , though?  In terms of overall debt too deficits , the Fed does non pose that much of a threat. Or , possibly I should say , other things are worse. The Fed's residue sail is "only" $3 trillion dollars. Even if it lost one-half of its assets , $1.5 trillion is ane year's worth of Federal deficits ,  10% of gross domestic product , or 10% of the national debt. Losses on the Fed's portfolio are non going to bankrupt the province or send us to hyperinflation. The Treasury tin sell bonds too hand them to (sorry , "recapitalize") the Fed , too so heighten taxes to pay off the bonds.  (That said , it would last overnice to come across a "stress test" on the cardinal bank. Doctor , heal thyself.)

The existent danger , so , is political , non financial. Imagine the fallout if the Treasury has to bail out the Fed to the melody of a few hundred billion dollars. The Fed would sure as shooting lose a lot of independence.


Current thinking virtually monetary policy values the independence of the cardinal bank.  An independent cardinal banking concern is a mode for the authorities to precommit ex-ante that it won't endeavor to goose the coin render ex-post roughly elections. 

But the toll of independence is express authority. You cannot , inward a republic , get got appointed officials amongst real long tenure writing checks to voters , allocating credit to specific industries , choosing winners too losers , or signing upwardly the Treasury for trillions of dollars of taxation liability.  The Fed cannot driblet coin from helicopters equally Milton Friedman in ane lawsuit recommended; that's called a transfer payment. The Fed tin , inward theory , alone purchase too sell rubber securities of equal value. As dysfunctional equally Congress too Administration may last , taxing too spending are their undertaking , equally they confront the voters.

Of course of educational activity , Federal Reserve actions get got ever had financial consequences. For much of history , the master copy role of cardinal banks was to lower the involvement charge per unit of measurement on authorities debt , past times making that debt to a greater extent than liquid.  And its "independence" has ever been a relative thing equally well. So equally inward many things , at that topographic point is a sliding scale. But our Fed has sure as shooting moved dramatically inward the direction of actions amongst of import , straight financial consequences. It must send some cost of less independence equally a result. We'll come across what that is.

But potential portfolio losses strike me equally a tip of the iceberg of actions that threaten the Fed's independence. The Fed participated inward bailouts of specific companies too industries. It allocated credit to specific markets. In its expanded role equally regulator it volition last telling to a greater extent than too to a greater extent than banks how to run their businesses. It is forthwith speaking to a greater extent than too to a greater extent than loudly virtually taxation too spending policy , such equally advocating mortgage bailouts. Its is setting "financial policy" to a greater extent than than "monetary policy."
The Fed is non probable to stay equally independent inward this expanded too real political role.

One thing is clear -- our monetary policy too cardinal banking institutions are evolving fast.