The Federal Reserve under Chairman Ben Bernanke has become the third-largest hedge fund in the world. The central bank has a relatively small base of assets, totaling $55 billion. The largest hedge fund, Bridgewater Associates, has more than $75 billion in assets.
However, the Fed is able to borrow more money than other hedge funds because it is allowed to create money. Leverage of 55-to-1 allows the Fed to control more than $3 trillion worth of bonds. Normal hedge funds are generally limited to leverage of less than 30-to-1 because market disasters happen above that level.
Given the Fed’s immense holdings, its returns look relatively small, with a gain of only $89 billion last year, or about 2.9 percent. However, potential risks look very large.
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Losses will mount quickly as interest rates rise. Fed holdings could lose about 7 percent in value for each 1 percent rise in the interest rate.
If interest rates go up 1 percent in a year, the Fed could report a loss of more than $210 billion. That is actually the best-case scenario.
The Fed is continuing to buy bonds, and increased assets mean even greater losses will accrue when interest rates rise. The Fed is also buying bonds with longer maturity dates, which will increase the amount of the losses when rates do rise.
No one outside the Fed really knows where the money will come from to cover these losses. Now the Fed gives all of its profits to the government to help reduce the deficit. If Fed losses are eventually covered by taxpayers and added to the deficit, taxpayers would be facing hundreds of billions of dollars in unfunded liabilities.
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