The Most Profitable Bank In The World

Please prepare yourself for a mind-bending exercise. Put aside everything that you think you know about economics and money. In the next few paragraphs we are going to explore something that many people outside the world of finance may struggle to understand. Nonetheless, bear with me for a few minutes and I think you'll find this information to be enlightening, entertaining, and even disturbing (or some combination of all three reactions).

Here are the facts: on Tuesday, January 10th, the Federal Reserve Bank announced that it made a profit of approximately $79 billion in 2011, and would pay approximately $77 billion of this amount to the U.S. Treasury (it is standard policy for the Fed to return all of its surplus earnings to the Treasury each year). You can view the full text of the press release here. Now to the surprising parts:

• With $79 billion in profits, the Federal Reserve made more money in 2011 than ExxonMobil (XOM), Apple (AAPL), and IBM (IBM) - combined.
• With a projected federal budget deficit of approximately $1 trillion for the current fiscal year, this contribution from the Federal Reserve's profits will actually decrease our nation's budget deficit by approximately 8% (because the Fed returns all of its profits to the Treasury, it has the effect of reducing our annual budget deficits)
• The Federal Reserve System employees 17,000 people, from its Chairman all the way down to part-time administrative staff, and the average salary of a Federal Reserve employee was about $88,000 in 2010 (the most recent year for which Fed payroll data is available). Therefore, with a net profit of $79 billion, this tells us that the Federal Reserve System produced an average profit of $4.6 million per employee!

This is all pretty amazing stuff. If the story ended right there, you might think the following: "Gee whiz, these people are geniuses! These Federal Reserve employees must be the smartest, most productive human beings on earth! They work really hard, make gobs of money, and then give it all back the U.S. Treasury to reduce our budget deficits!" Why can't those folks at Apple and Exxon Mobil figure out how to do a better job?" If you're reading all of this with a puzzled look on your face, you are not alone. The simple explanation is this: The Federal Reserve can make so much money in a given year because it literally has the authority and the power to "make money."

As you know, the Fed's quantitative easing programs have led to large scale purchases of financial assets, primarily U.S. Treasuries as well as government guaranteed mortgage backed securities. At this time, the Federal Reserve holds roughly $3 trillion in fixed income securities, mostly government and agency bonds. Where did the Federal Reserve get the money that it used to buy all of those bonds? It created the money, of course. The Federal Reserve bought trillions of dollars' worth of bonds with the money that it created out of nothing. Now, the Fed is collecting all of the interest payments on those bonds, calling it a "profit," and returning the money to the Treasury to reduce our budget deficits.

Just for fun, let's take this situation to the extreme to see what happens. Let's do a thought experiment and imagine the Fed buying all outstanding Treasury and agency securities. Using rough numbers, the Fed could buy up $10 trillion or so in outstanding government debt, plus $8 trillion or so of securitized agency mortgage debt, for a total of $18 trillion. Assuming an average coupon yield of 3% across this $18 trillion portfolio, we would calculate the Fed's interest income to be about $540 billion per year. The Fed would then claim a profit close to this amount, pay the money to the U.S. Treasury, and the net effect would be a 50% reduction in our government's annual budget deficit.

There are a number of disturbing aspects to this situation and it exposes one of the often-incomprehensible features of paper money systems - also known as "fiat money." Our government, through the U.S. Treasury, can issue debt, while another agency of the same government - the Federal Reserve - can buy that debt, collect the interest payments, and actually return the interest income to…the U.S. Treasury - the same agency that issued the debt in the first place! It's easy for this sort of arrangement to confuse people, because most logical people recognize the obvious circularity of the money transfers. However, since we lack a real-world analogue to this arrangement, it can be hard to get our minds around all the implications the first time we think about it. Feel free to read it again and take it all in, if you need to.

This situation also illuminates the central reason why many people are buying physical resources - gold, oil, farmland, etc. The Federal Reserve's actions clearly demonstrate the counterfeiting nature of central monetary authorities who have, throughout history, enabled fiscally-malfeasant nations to run unsustainable budget deficits and inflate their currencies to the point of being worthless. Some people have a hard time understanding the value of gold or the rationale for owning the yellow metal, and I'll confess that I am sympathetic to their dilemma; there was a time when I used to ask myself these questions. If you are such a person, I suggest that you ask yourself a different question: what is the value of paper money, which can be created from nothing, in infinite quantities? When you begin to explore this question, the rationale for ownership of gold and other physical resources becomes a foregone conclusion.

Disclosure: I am long GLD. I am long numerous oil and resource stocks.