Lighthouse Investment Management

Happy Centennial, dear Fed!

In what could easily be the "tweet of a decade", Jim Rickards ("Currency Wars") recently stated:

These words contain a lot of information that needs to be deciphered. "Perpetual non-interest bearing notes". Yes, dollar bills are notes, or debt instruments. It actually says so at the top of every dollar bill:

Federal Reserve Notes are legal tender, meaning you can walk into a store, take an apple, and the cashier must accept your dollar bill as means of payment. At the time of the creation of the Fed (1913), the law states for notes to be redeemed in gold or "lawful money". The gold convertibility obligation ended with the Emergency Banking Act of 1933. So if you presented a note to the Fed today and demanded payment, the Fed would simply "pay" you with another note. People think of dollar bills as "money" when they are actually debt instruments. You don't get any interest on them, and they have no maturity. Rickards hence correctly calls them perpetual non-interest bearing notes. You might be forgiven for thinking dollar bills were issued, or at least guaranteed, by the United States of America. The letters "UNITED STATES OF AMERICA" adorn each dollar bill. You notice the seal of the

Letter to investors - January 2013

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Lighthouse Investment Management

US Treasury Department and the signature of Treasury Secretary, all suggesting this paper comes from the US government. However, the Federal Reserve System is owned by twelve Federal Reserve District Banks. "The Federal Reserve Banks are independent, privately owned and locally controlled corporations."1 The Fed even entertains different websites (to confuse the public?); one (www.federalreserve.gov) which carries all the communication regarding monetary policy, with the domain ".gov" suggesting it is a government-related entity. A second one (www.federalreserve.org) is password-protected, with a third one (www.frbservices.org) also not using the .gov domain. "But doesn't the President of the United States have to confirm the chairman of the Fed"? Yes, he does, but he can only chose to confirm the one suggested by the "Board of Governors of the Federal Reserve System". As you may have noticed, the Federal Reserve System has little to do with the US government and is privately owned. The Fed's balance sheet is pregnant with roughly $3 trillion in assets, on par to add another trillion in 2013. By the end of 2014, the "Bank of Bernanke" might be looking at $5 trillion in assets. Rising interest rates would lead to (mark-to-market) losses for bonds. A 1% decline on $5 trillion of assets would translate into a loss of $50bn. How much capital does the Fed have?

United States Court of Appeals for the Ninth Circuit in Lewis v. United States, 1982

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Yep, the largest hedge fund of the world has a mere $54bn in capital, or 1.8% of assets. The Fed, of all banks, is levered 55-to-1, potentially going to 100 1 within 2 years. Of course, any banking regulation 1, 100-to-1 (think increased capital requirements) doesn't apply to the Fed. I know, any losses will be "treated" as a capital account with the Treasury with a negative balance. However, should the US government refuse to fund the Fed, it would be bankrupt for all purposes. As the US government would also be bankrupt without the Fed (the Fed purchases most of the net issuance of Treasury bonds in order to finance the large deficit), none can live without the other. At some point the US government will simply "cancel" a bunch of debt held by the Fed (in order to optically reduce the debt-to-GDP ratio). Which will be the indication for the public to realize what this GDP really means: fiat money has become worthless by first 'printing' it en masse (to the tune of 30% of GDP2), then ripping it up again. Now that we explained the 'insolvent' part, we come to "the concept of gold as M0". When the public loses confidence in fiat (paper) money, a return to the gold standard might be the only way to reestablish a working monetary system. "M0" (Monetary aggregate 'zero') describes part of the monetary base consisting of notes and coins in circulation. Rickards simply refers to a gold standard, ary where all notes and coins in circulation are convertible, and hence must be covered, by gold. Not enough gold around? Just a question of price. The US holds 8,133 tonnes of gold (or 261m ounces). In order to cover the entire M3 of $15 trillion (coins, notes, bank deposits, money market funds) the gold price would simply need to rise to $57,000 per ounce. Then you do a currency reform (by cutting of two or three zeros), and everything's fine. e Carmen Reinhart and Ken Rogoff presented this chart at the 2013 AEA meeting. It shows how the consumer price index was fairly stable for 150 years, partially under gold standard. standard 100 years after the creation of the Fed and 42 years after the end of the gold standard inflation has gone into parabolic ascent. The days of fiat money seem numbered. Happy Centennial, dear Fed!

Assuming $5 trillion in Fed assets by end 2014 and $17 trillion GDP

Letter to investors - January 2013

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