 Good morning, ladies and gentlemen, and thanks to the Mises Institute and to sponsor Yusuf Amayyad for this opportunity to be with you all today as we consider what I think is really one of the most remarkable developments in the history of American central banking, money printing and credit inflation. Let me say on a personal note, the pursuit of clarity has long been a personal goal of mine, and it's a particular pleasure to present a lecture in honor of Henry Haslott, whose work was marked by such clarity of style, meaning and logic. While taking up our topic, Haslott Hayek and how the Fed made itself into the world's biggest savings and loan, we begin with Haslott's economics in one lesson. Of course, central to the celebrated book is the key problem of government policies, which benefit one group only at the expense of all the others. Now it seems to me we have a striking instance, a really big and important one of this problem in the Federal Reserve's huge investment in monetization of a giant pile of real estate mortgages, demonstrating this eternal political propensity precisely to benefit one group at the expense of all the others. Now Haslott writing about this propensity went on to say, quote, the group that would benefit by such policies having such a direct interest in them will argue for them plausibly and persistently with the best viable minds, a great phrase then, the best viable minds. And they'll devote their whole time to presenting its case with Haslott's endless pleadings of self-interest. Such pleadings have certainly characterized the housing and the housing finance industries over many decades. In Haslott's day and in ours, and you have to say with notable success and have resulted in the massive interventions of the United States government into housing finance. Through Fannie Mae, Freddie Mac, and Ginny Mae, if we just add up their financial statements, the government guarantees about $8 trillion in mortgage debt, that's $8 trillion of credit risk for account of the taxpayers. In the latest radical expansion of this involvement, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve, the central bank. And getting mortgages into the balance sheet of the Federal Reserve was, in my view, a fateful step. Now as of right now, March 2022, the Fed owns a quite remarkable sum of $2.7 trillion worth of mortgages, of mortgage securities. And what that means is that 23% of all the mortgages there are in the country, which add up to about $11 trillion, 23% of all the mortgages there are, are on the balance sheet of the central bank. This is really a pretty astonishing. Moreover mortgages have become 30% of the Fed's own bloated total assets. Now these numbers would most certainly have astonished the founders of the Federal Reserve. Indeed, I'm enjoying imagining them in political and financial Valhalla, watching all this and engaging in a lively but very puzzled discussion of how their creation came to be a monstrous mortgage funder. Of course, these developments are not astonishing to students of Haslott, Hayek, and Mises, who expect governments and central banks to always be reaching for more power and reaching beyond their knowledge. Since March of 2021, so in one year, the Fed has added to its mortgage portfolio $557 billion, or in other words, about $46 billion a month. On average, it has made this mortgage portfolio get bigger. It actually had to buy a lot more than that because that's the net increase in the portfolio to make it go up that much because you first have to replace all the repayments and prepayments of the underlying mortgages. So the Fed has become a very big actor indeed. We can say the big bid with two capital Bs, the big bid in the mortgage market, has become the central bank. This has been a very reliable bid for the dealers in these securities and a market distorting bid, of course, as just we were saying a minute ago, as the Fed has been buying mortgages with one hand and printing money with the other hand to finance all the buying. Now at the same time, as we know, there's been an amazing house price inflation. We've had an inflation in general of asset prices in the country and in the world, but a notable house price inflation. U.S. house prices, on average, went up about 17 or 18 percent last year, depending on how you measure, but an enormous amount, a far bigger amount, of course, than incomes or than economic growth. And in January of this year, they were still rising at the annualized rate of 17 percent. They are, the average American house prices are far over, far over the peak that they reached during the mortgage bubble, that infamous, deservedly infamous, we should say, housing bubble. The peak was in 2006. We are now far over that. And in real terms, inflation adjusted for inflation were also over it. And we remember that after that last peak, 2006, house prices fell for six years, from 2006 to 2012. Well now, we think about this giant housing sector. The current market value of all the houses in the country is a number something like $38 trillion. This is a massive sector. And it's, once again, 20 years after that last peak in the infamous bubble, characterized by runaway house price inflation, making it, of course, fine if you're a holder of a house, but tougher and tougher if you're somebody trying to buy one. Now faced with this rapid escalation in house prices last year, 2021, they fed unbelievably kept on stimulating the housing market by buying more and more mortgages right up to now to this month. It thus further inflated the housing bubble, subsidized mortgages, distorted house prices, and very importantly, it distorts land prices, which, when you buy the house, you're also buying the land. And a lot of the speculative and inflationary energy created by the Fed goes into inflating land prices. Now I don't think we can discover a more perfect example of the dangers of central bank behavior and its effects than this as these effects are seen by Austrian economics. It's really a great example for us to study. Now the way I think about this is that by acquiring these $2.7 trillion in mortgages for its own balance sheet, the Federal Reserve has made itself far and away the biggest savings and loan institution in the world. Like the savings and loans of old, the Fed owns very long fixed rate mortgage assets. It neither marks its loans to market in its financial statements, nor does it hedge its extremely large interest rate risk. So in this 30% of its balance sheet, it in fact looks just like an old style savings and loan. Like the savings and loans of the 1970s, it has loaded up on 15 and 30 year fixed rate mortgages just in time now to experience a threateningly high inflation. In this case, of course, the inflation is of its own making and those house prices, which it's been inducing the inflation of, flow in to the consumer price index and the cost of living through what's called the owner's equivalent rent of primary residence statistically. But of course, as the house price goes up, the cost of living rises with it. Now if he were with us here with inflation running at almost 8%, Hazlet would not be surprised that we're again facing the problem which was so prominent during his own lifetime. Because in spite of the fact that we keep having these recurring painful and costly experiences with inflation, as Hazlet observed, quote, the ardor for inflation never dies. A great line, the ardor for inflation never dies. Now by inflation, he doesn't mean the price rise there. He means in a good Austrian sense, the excessive credit and monetary expansion. That's the inflation for which the ardor never dies. That's the cause and the subsequent galloping increases and prices with all of their effects are the effects of the cause. Now human nature being what it is and especially human nature in political power being what it is, central banks and politicians think maybe they can have the cause, the monetary expansion, without the effect, the galloping prices, they can't. But they try, alas. Now writing in 1978 in his book, The Inflation Crisis and How to Resolve It, happily republished by the Mises Institute, and I saw this morning for sale right out here, Hazlet wrote, quote, Inflation, now this is 1978, inflation not only in the United States but throughout the world has not only continued but spread and accelerated. The problems it presents in a score of aspects have become increasingly grave and urgent. Well, sounds pretty familiar. Here we are. Hazlet pointed out a central irony of this situation, which is often struck me as well. He wrote, the subject is so much discussed today, the subject of inflation, the politicians in Washington talk of it as if it were some horrible visitation from without. This inflation is something that happens from outside, something they are always promising to fight. Of course, nothing is so ironic as the central bank promising to fight the inflation and Hazlet goes on, the plain truth is that the political leaders have brought on the inflation so you're fighting what we created ourselves. I also think in this context of the great Friedrich Hayek, in his lecture upon accepting the Nobel Prize for Economics in 1974, who observed, quote, economists are at the moment, 1974, are at the moment called upon to say how to extricate us from the serious threat of accelerating inflation which it must be admitted has been brought about by policies which the majority of economists recommended and even urged governments to pursue. And so as we said, here we are again. Now it's superfluous to say, while speaking at the Mises Institute, that among the economists urging inflationary policies were not those of the Austrian school, then are now. Now the people of late with the hottest ardor for inflationary policies have of course been the advocates of the so-called modern monetary theory or MMT. Now I always say this is being written and abbreviated wrong. This should be written, quote, modern, unquote, monetary theory. Thank you. Or quote, M, unquote, MT, because as we all know, there is no notion older than that if the government is running short of money, it should just print some up. This quote, M, unquote, MT might equally of course be called ZMT, that Zimbabwe monetary theory or reflecting classic adventures in monetary thought and experience JLMT, that's John Law monetary theory. Now Haslott has a fine term for those of this persuasion. He calls them the paper money statists. And indeed the real agenda of MMT is a political one, namely to have no limits to the government's ability to spend. That's the real point, isn't it? Needless to say, or at the Mises Institute, this is an illusion because the most fundamental of all economic principles is this, nothing is free. Not only lunches aren't free, nothing is free. And it's good to repeat this principle, nothing is free, and we ought to put it over the door of every economics department along with the idea so well explored in economics in one lesson that you have to see all of the costs of government decisions. And of course, when we consider the printing which leads to inflation, that has a very heavy cost indeed. Now with the galloping inflation we've got now, we shouldn't be hearing too much from the MMT routers. So I hope that we can write at least for this politically economic cycle, doubtless it will raise its head again in the future. But for this cycle, MMT RIP. Now if we combine the current almost 8% year over year inflation with nominal interest rates, say on savings rates about 0.1%, according to the FDIC, of course we get a real interest rate on savings of negative 7.8%. Alternately said, the Federal Reserve is expropriating 7.8% a year of your savings or your money market fund account. Now in a true market we should ask ourselves, compared to that negative 7% or 8% real interest rate on savings in a true market, what would the real interest rate on savings be? You know we don't know what it would be because to find that out you need a free market, a free market in money. And we don't have one. We have a completely central bank dominated market, needless to say. But we can I think with very high confidence say in a true market the real interest rate on savings would not be minus 7% or 8%. You can only get that kind of number if you have a central bank. And of course at the moment inflation is being made worse by the effects of the war in the Ukraine, the kind of war that many people thought could not happen again in Europe. And unfortunately in this case to use this wonderful line, many things which had once been unimaginable nevertheless came to pass. That's a great epigram from physicist Freeman Dyson. Many things which had once been unimaginable nevertheless came to pass. That's one of the reasons why central planning won't work as we know. Now at the same time the United States is waging as we know a pervasive economic war to accompany the shooting war with tumultuous volatility in financial markets and as yet still developing but surely very large economic effects on the way. We already know that increases in the prices of energy wheat and other commodities will push up essential consumer prices even further. The spike really quite remarkable in the price of nickel has caused a crisis on the London Metal Exchange which forced them to stop trading. Many people think we're about to have defaults on Russian government debt and there'll be lots of other effects working their way through the system which causes us to remember that big wars are the most important forces in financial history and in economic history. Talk about a lot of other things but if you take the sweep of history the thing that causes the biggest changes economically and the biggest changes financially are wars. Now we have a very significant war underway, a shooting war and an economic war. Now this made me think a little bit about history and so I went back to the post-World War I era. This is around the early 1920s when Hayek was in his early 20s. Mises was about 40 at this point and we had this very nice description I found in the introduction to Mises collected works. Quote, Austria lost everything in the war. Vienna became a capital without an empire. Quite a nice turn of phrase. There was no way to measure the cost of all the conflicting financial claims and then later on we know these all led to massive defaults on sovereign debt in the 1930s. Quote goes on, there was rampant inflation, hyperinflation in Germany which we all remember but also hyperinflation in Austria which ruined the holders of bonds particularly the class to which Hayek belonged followed by steep deflation especially in the United States and commodity prices and production in disarray throughout the world such are the results of wars. Long before the present war began we observed our Federal Reserve completely surprised by the emergence of the inflation which its own actions had created. Now a far better forecast of the inflation that was coming based on the fact that the level of spending and deficits and monetization after the financial panic of 2020 looked a lot like those of the big war. Based on that analogy the well-known financial thinker Charles Goodhart and his co-author Manoj Pradhan predicted while writing in 2020, quote, what will then happen as the lockdown gets lifted and recovery ensues following a period of massive fiscal and monetary expansion? The aftermath as in as after many wars they wrote will be a surge in inflation more than 5% or even on the order of 10% in 19 in I'm sorry in 2021. So in 2020 they made the excellent forecast for 2021 of 5% to 10% inflation. While they were making this excellent forecast as we know the Fed was forecasting inflation of 1.8% for 2021 and a egregious miss. Goodhart and Pradhan went on to say what will the response of the authorities be and writing in 2020 they predicted first and foremost they will claim this is temporary. Once for all blip and this was as we know a perfect prediction of the by now highly embarrassing transitory line taken by the Fed and the administration now needless to say this this raises a much larger issue about central banks in general and the Fed in particular a question very much in the Austrian spirit which is put it this way does the Fed know what it's really doing and the answer is of course no the Fed does not know with any confidence what the results of its own actions will be that is to say what it's really doing. Let's go further can the Fed know what it's really doing and again the answer is no the Fed will always have a theory whatever theory is currently in fashion because central banking is a very fashion following enterprise in the Fed there'll be hundreds of economists and as many computers as it wants but it can't ever have the knowledge you would need to be the centralized manager of a complex financial system let alone of an enter pricing large market economy now this of course sounds familiar here at the Mises Institute this inevitable lack of knowledge but think about this the inevitable lack of knowledge combined with great and it seems ever growing power is why the Federal Reserve is as I think the most dangerous financial institution in the world. Coming back to the mortgage portfolio of former Fed Chairman Ben Bernanke is the father of the Fed's giant mortgage portfolio in 2012 when he'd been chairman of the Fed for six years Bernanke expressed the knowledge problem of the Fed with remarkable intellectual honesty said Chairman Bernanke quote the fact is that nobody really knows precisely what's holding back the economy what the correct responses are or how our tools will work. He told this to his Fed colleagues on the Federal Open Market Committee he proceeded to characterize the next round of asset purchases which would include of course include mortgages which he was recommending as quote a shot in the proverbial dark unquote so I say I think this is a remarkably intellectually honest statement unfortunately it was a communication inside the Fed not a candid confession to the outside world and one needs hardly to say to such an audience as you all are that the inescapable problem of knowledge the impossibility of centralized possession of the requisite knowledge and therefore the impossibility of successful socialism or of dirigeced central banking was a more immortally taught us by Mises and Hayek and to think otherwise requires in Hayek's fine phrase a pretense of knowledge. Now I want to just pause here a minute to think for a minute about the metaphor of a mechanism it's a really powerful metaphor to imagine that things are mechanisms and some things are mechanisms and things which are mechanisms can be highly successfully dealt with by engineering and mathematics and control but central to the knowledge problem of central banks and of anyone is the fact that an economy with its intertwined financial system that's one thing the economy and the intertwined financial system is not a mechanism can't be controlled and predicted as a mechanism but it's really notable how widespread the metaphor of mechanism is in economics. Economists talk all the time for example of the monetary transmission mechanism or the European financial stability mechanism but we're not dealing with mechanisms but with a different order of reality a different kind of reality I feel safe at the Mises Institute getting a little metaphysical with you all a different kind of reality but what kind of reality is it them a complex enterprising market economy with its intertwined financial system. Well as many of us know already it's a catalaxie. How do we name something which is not a mechanism? Hayek wrote in 1970 you may be familiar with this quote it seems necessary to adopt a new technical term to describe the order of the market which spontaneously forms itself by analogy with the term catalactics he said used for example by Mises in human action Hayek goes on we could describe the order itself as a catalaxie. Hayek's footnote to this paragraph adds the ends which a catalaxie serves are not given in their totality to anyone. Unquote and not given to any economic actor to any macroeconomist to any central bank or any other would be philosopher king. Now this proposal for a profound and it seems to me very useful new word was made more than 50 years ago and it obviously has not succeeded in gaining popularity. Indeed in most companies that you'd be in the word catalaxie would I suspect elicit a lot of blank stares even among knowledgeable people and we must admit it does have a rather unattractive sound and seems obscure and academic but it's a great way to name the fundamental reality. What is this fun odd kind of fundamental reality we're trying to name and infinitely complex recursive full of millions of feedback loops self referencing expectation all interaction of human actions and human values marked always by fundamental uncertainty in which ideas become reality previously unimaginable innovations appear and as Freeman Dyson said previously unimaginable things keep happening and experts like the Federal Reserve are frequently surprised this reality cannot be thought of in any simple way it's much easier to think of a mechanism or an algebraic formula than it is to picture or intellectually grasp a catalaxie well it's really too bad the word hasn't caught on to express this fascinating type of reality which we all work to understand no now back to our story and back to the ranch into the American catalaxie strode the Federal Reserve its pockets filled with newly printed dollars and it's printer handy to create more and bought up the biggest pile of mortgage assets that anybody ever owned it bought even more treasury securities accumulating $5.8 trillion worth of them so that its balance sheet has reached the memorable total of $8.9 trillion now this itself is another development not imagined by anybody beforehand including the Fed itself $8.9 trillion today is twice the Fed's total assets of two years ago of March 2020 and 10 times its total assets which were 875 billion in December 2006 and the Fed's just before the crisis set off by the housing bubble twice the I'm sorry 10 times the total assets of then and now we come to the mortgages the $2.7 trillion in mortgages is twice the level of two years ago of March 2020 but far more to the point it is infinitely greater than the level of mortgages in the Fed's balance sheet in 2006 which was zero and the organization of the Federal Reserve in 1914 until 2006 the amount of mortgages it always owned was zero that defined normal well what's normal now should a Federal Reserve mortgage portfolio be permanent or temporary or perhaps transitory can the mortgage market now so accustomed to having that Federal Reserve bid and Federal Reserve hold all of that interest rate risk even imagine a Fed which now which now would own zero mortgages can the Fed itself even imagine that so here's a key question should the Federal Reserve's mortgage portfolio not just shrink some but go back to zero I would say and I suspect most of you would too that it should go back to zero from 2.7 trillion to zero now in the beginning of its buying mortgages that was clearly the Fed's intent chairman Bernanke testifying to Congress about his bed about his bond and mortgage buying program so-called QE I said in 2011 in congressional testimony quote what we are doing here is a temporary measure which will be reversed and the Fed's intention is to make sure that the Fed's interest buying here is a temporary measure which will be reversed a temporary measure which will be reversed so we went on at the end of the process the money supply will be normalized the amount of the Fed's balance sheet will be normalized and there will be no permanent increase either in money outstanding or in the Fed's balance sheet well another bad forecast as we can see now 11 years after that testimony was delivered but no that doesn't mean the intentions were not sincere at the time for example Elizabeth Duke who is a Fed governor from 2008 to 2013 said quote I genuinely believed that it was a temporary program and that our balance sheet would go back to normal now that's a quote I took from a recent book Lords of Easy Money which has a lot of good anecdotes in it and that book also relates excuse me that as far back as 2010 the Fed was debating how to normalize by how to normalize them and how to take all the bond purchases back to what they were before which would mean zero in the case of mortgages they were debating how to normalize credible arguments were made in the inside the Fed discussions that the process of getting back to normal would be completed by 2015 meaning that the Fed would have sold off the assets it purchased through quantitative easing. A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed's investments would quickly expand during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds after that the balance sheet this presentation went on would start to shrink gradually as the Fed sold off the assets it bought with assets falling to under $2 trillion by 2019 well another bad forecast on the other hand any of us and that certainly includes me who tried our hands at financial forecasts will not be so hard on people who make mistaken projections having made so many mistakes ourselves but look how clear it is that the Fed has no greater ability than we do more than anybody else does to foresee the financial and economic future to foresee its own future actions foresee its own future balance sheet or state that it can't know what it is or will be doing and note that it kept talking about selling these descriptions talked about they would be selling assets so early on in these discussions the Fed realized that if it did sell assets and if things were normalizing interest rates would have gone to higher levels prices of bonds and mortgages would of course have gone down but the Fed could be realizing significant losses on the sales of the very long term fixed rate assets it bought of course so far the Fed has made no sales yet and come back to this problem of losses on sales in a minute over the last few decades US financial actors have believed in and have experienced as a reality the Greenspan put the Bernanke put the Yellen put and the Paul put this is the belief that the Fed will always manipulate money to save the day for financial markets and leveraged speculators and these puts of risk to the Fed have themselves over time induced higher debt inflated asset prices including inflated house prices and made the whole system more risky and more in need of these puts now thinking of needing puts let's think about two years ago today that would be March 18th 2020 we were in the midst of the COVID financial panic a true financial panic occurring in these times as everyone will remember the prices of all kinds of assets were dropping like so many rocks fear and uncertainty were rampant and the Federal Reserve and all other major central banks all the major central banks in the world having adopted Walter Badgett's famous theory that central banks need to lend freely to financial actors in a financial panic applied Badgett's theory to the max the central banks also as we will know monetize the huge deficits being run by governments to offset the steep financial correction which followed their lockdowns and printed however much money it took to cover the deficits resulting from the emergency programs of the governments of which they are apart and it can't be said too often we know it but it can't be said too often that the real first mandate of every central bank and you never find it in the PR statements of the Federal Reserve the real first mandate is to finance the government of which it is apart and that's why governments all want to have and love having central banks now the panic did end as we know normal financial functioning was restored and not only functioning but quite wild arguably bubble bull markets resumed starting in mid 2020 among other things fueled by the monetary expansion then came as it must come the question what do we do when the crisis is over well all right we had the panic we printed now the crisis is over what do we do now well we know what the Fed did was keep right on buying mortgage securities and treasury bonds by the hundreds of billions of dollars now this demonstrates an abiding problem how do you reverse central bank emergency programs originally thought and intended to be temporary after the crisis has passed the principle that interventions made in times of crisis need to be withdrawn after the crisis is over I call the Cincinnati and doctrine now you may recall the ancient Roman hero Cincinnati's Kinkinatus who was as it is said called from his plow to save the state he was made temporary dictator a formal office of the Roman Republic he did save the state and then mission accomplished resigned his dictatorship and went back to his farm similarly to millennia later George Washington victorious general and hero who had saved the new United States and could perhaps have made himself king instead in a deservedly celebrated moment resigned his commission and went back to his farm thereby becoming the modern the modern Cincinnati's as he was called and you may remember that King George III upon hearing this said if this be true he is the greatest man of the age which he probably was in contrast emergency central bank innovations however sincere the original intent for them to be temporary build up economic and political constituencies who profit from them and want them to be continued and will certainly acquire the best viable minds to try to see that that happens and of course for central bank monetization of government debt the biggest and most important constituent of who is benefited by that program is the government itself so it's clear we have difficulty in winding emergency actions back down once they're become established and profitable to their constituencies and I call that the Cincinnati and problem there's no easy answer to this problem how so to speak you get the fed to go back to its farm when it's become the dominant mortgage and bond investor in the world how will it go back to its farm and withdraw from being the world's biggest savings and loan. Two days ago on March 16th the Fed announced that it quote expects to begin reducing its holdings of treasury securities and agency debt securities and mortgage back securities at a coming meeting quote in the future but coming soon for the moment it's going to keep buying because it's going to replace the runoff of its current portfolio but it did say that shrinkage maybe the shrinkage coming maybe quote faster than last time in this the Fed is already very late and long overdue back at its farm. Now this week the Fed announced that it would continue to reduce its holdings of treasury yield on the 10-year note reached 2.2% and long-term mortgage rates are up to four and a quarter percent. These rates now seem to us high so quickly do our perceptions adjust to whatever we've currently gone through but of course historically speaking especially compared to the galloping inflation we've got they are very low interest rates. Historically speaking a more typical rate with a 10-year treasury note would be at least 4% or more and for mortgages 5% or 6% the interest rate on the 30-year mortgage for example was never less than 5% in this country from the 1960s to 2008 so 4 is really low yet. Now if the Fed stops suppressing mortgage interest rates and stops being the big bid for mortgages how much higher the interest rate is will those interest rates go from their present historically very low level and when these interest rates rise how quickly will they put out the runaway house price inflation and this leads to another question as I mentioned a minute ago about the Fed itself. How much higher as those interest rates go how much higher we don't know but as they rise how will the losses on the Fed's own mortgage portfolio and on its even greater portfolio of treasury securities develop how big could they be could the losses on these portfolios be big enough to make the Fed insolvent on a mark to market basis and the answer to that is yes they easily could. So let's take a minute to do a little bond math the duration of the Fed's 2.7 trillion dollars in mortgages is estimated at about 5 years. 5-year duration means that for each 1% that long term interest rates rise the portfolio loses 5% of its market value so 1% rise would be a loss in market value of 5% of 2.7 trillion dollars that's 135 billion dollars and a 2% rise in mortgage rates easy to imagine at least easy for me to imagine would be a market value loss of 270 billion dollars. Now let's come to the 5.8 trillion dollars of treasury securities on the Fed's balance sheet. And by the way not only does it own 23% of all the mortgages there are but the Federal Reserve owns 24% of all the treasury debt there is in the hands of the public. The Fed being counted as part of the public for this measure 24% of all the treasury debt is on the books of the central bank and only a small proportion of it is in short term treasury bills a lot of it is very long a lot of it actually is over 10 years long 1.4 trillion dollars over 10 years. So the Fed is not very open about what the duration of this portfolio is so I try to estimate the duration of the whole treasury portfolio and came up with about 5 years. Trying to test my arithmetic I came up with about a Wall Street contact to tell me what they thought and he said 7 years but let's use 5. Same math on a 1% interest increase in rates the losses on a 5 year duration is 5% of the portfolio. So on the treasury portfolio that would be a net loss of 285 billion dollars on a 1% rise in market value and on the 2% rise in long interest rates and on the 2% loss of 570 billion. These are really big numbers they could even get the attention of a central bank and I am quite positive that inside the Fed they do have their attention where they are surely calculating very carefully their durations and their negative convexity and their sensitivity to market value losses. So if we add the mortgages and the treasuries together you get on pretty plausible increases in interest rates market value losses of around numbers like 400 billion dollars to 800 billion dollars. So okay keep those in mind and let's think about the net worth of the Federal Reserve system because you know the Federal Reserve banks really are banks and they really do have a balance sheet. They have assets and liabilities and they have capital. So what's the capital of the Federal Reserve system on a consolidated basis? Anybody know? Well it's 41 billion dollars 41 billion but you could easily think of market value losses of 400 to 800 billion dollars when interest rates rise. Well that's pretty interesting. Also the Fed is extremely highly leveraged. Anybody know what the leverage of the Federal Reserve's balance sheet is? We know what banks we talk about maybe 15 to 1 or 20 to 1 or really egregious 30 to 1. What's the leverage of the Federal Reserve's balance sheet? Well ladies and gentlemen it's 217 to 1 or hyper leverage but you know they're special. They're a central bank but for anybody except a central bank with such hyper leverage to have such huge sensitivity, such huge interest rate risk would be well would get them in trouble with whoever was regulating them. Now here's an interesting question. Does mark to market insolvency matter? If you are a fiat currency central bank and the vast majority of all economists say no and maybe they're right. If the Fed were mark to market insolven today and let's say people knew it probably nothing would happen. Would you keep accepting $20 bills in payment? You probably would and the Fed would keep accounting for its securities at par value which is how they account for them plus on amortized premium and the unrealized loss however massive would not touch the balance sheet or the capital account. Alright so now let's suppose that the Fed actually does, remember it hasn't sold any yet but let's suppose it actually does sell mortgages and bonds into a rising interest rate market and takes really big realized not now these are not unrealized mark to market losses these would be realized cash losses. So for example you have a mortgage back security you bought it 103 and you sold it for 98 and you lost five and that five is gone forever it's never coming back. What would happen wouldn't you have to wouldn't that go to your capital account and if the losses were big enough you'd actually have to book negative capital and report it on maybe people wouldn't care but at least you'd have to do it. Now it may surprise you to learn as it certainly surprised me to learn that even if the Fed had huge realized cash losses it wouldn't affect their capital at all. No matter how big the realized losses were the Fed's reported capital would be exactly the same as before. Well that ought to be impossible. So how is it possible? Well it's possible because in 2011 well considering how it might one day have to sell some mortgages and bonds the Fed logically I mean they know a lot about financial markets. The Fed realized that if interest rates went to normal levels they'd be selling at big losses. Well this caused them to ponder what could we do about this and so guess what they decided to do you know they decided to change their accounting. Now here's a handy thing if you're the Fed if you're the Fed you control your own accounting principles they're called Fed reserve accounting principles and you set them yourself and so they just changed the Fed reserve accounting principles and here's how they changed them. They changed them so that if you actually did have a realized loss on securities something you bought it for 103 sold it for 98 what would you with that $5 debit to speak bookkeeping here to you for a minute where would that debit go? Would it go to retained earnings and your capital account? No it would go to an intangible asset. Your previous losses would be a debit to your intangible asset and they have an obscure name for this intangible asset. Well this is you know clever you could say but it's hardly upright accounting. Let's say I'd hate to be the chief financial officer of an SEC regulated corporation who tried that one but your central bank has established that as its principal and here is a great irony. This is precisely what the old savings and loans facing insolvency did in the early 1980s. They called it in those days regulatory accounting principles. Well now we have Fed reserve accounting principles. The savings and loans just made it that is to say the old federal home loan bank board of dishonored memory made it so that if you sold your mortgages and lost money you just booked up a fake intangible asset. So isn't that ironic that the central bank having become the new biggest savings and loan in the world facing the same problems as the old savings and loans came up with the same accounting answer to the potential problem they might have. Now let's think as we get down here to our closing minutes about how the Fed reserve fits in to the whole mortgage system. The mortgage system is a huge very complex financial sector. Mentioned before there are about 11 trillion dollars of mortgage loans in the United States. Residential mortgages one to fours we call them in the trade. One to four family residential mortgage loans. Of those as I also mentioned about 8 trillion are guaranteed by the government. Well that's 70 percent. Does the government have to guarantee 70 percent of all of the mortgage credit risk in the country? Well of course it doesn't. Does it make sense for it to do that? Of course it doesn't. But it does. It makes me think of a memorable experience I had one time when we had a session in Denmark. Denmark has a really fascinating housing finance system. And we had a little session where they presented their system and I presented the American system based on government sponsored enterprises on Fannie Mae and Freddie Mac. And when my talk was done the CEO of one of the Danish mortgage lenders there said well now that was really interesting. He said you know we always say that America is the land of free markets and we here in Denmark are the socialists. He said but now I see in mortgages it's just the opposite. And so it was. Well American mortgage finance is dominated by this guaranteeing of the credit by the government but even more by a government mortgage triangle. There are really three parts of the U.S. government which dominate the mortgage system. Those are what we call the government mortgage complex. That's Fannie Mae, Freddie Mac, Ginnie Mae and Ginnie Mae associated with the federal housing administration. That's one leg of the triangle. The second leg of the triangle is the U.S. Treasury. The government owns 100% of Ginnie Mae and the U.S. Treasury is the majority owner of Fannie Mae and Freddie Mac owning all their senior preferred stock in 79.9%. They control 79.9% of their common stock through warrants. They have the exercise price of which is almost zero. Anybody know why it's 79.9%? It's because if it were 80% the government would have to consolidate the debt of Fannie and Freddie into the government's financial statements. They don't want to do that. They've never wanted to do it. In fact the whole reason, the principal reason that Fannie Mae was made into a so-called government sponsored enterprise in 1968 was to get its debt off the government's balance sheet because Lyndon Johnson's deficits were bigger than he wanted. They reorganized Fannie Mae. That's the government mortgage complex and then the Treasury. The Treasury of course effectively, not legally, but effectively guarantees all the debt of Fannie and Freddie. Now we have the Federal Reserve, which didn't used to be part of the government more. Then it was a government axis. Now it's a government triangle. The third leg is the Federal Reserve. They only buy Fannie and Freddie mortgage securities guaranteed by Fannie and Freddie. But Fannie and Freddie's guarantee is only meaningful because they are in turn effectively guaranteed by the U.S. Treasury. But now think about this a minute. Why is the U.S. Treasury's credit so good when it runs big deficits every year and only meets its cash obligations by more borrowing? Well the U.S. Treasury's credit is so good because the Fed will buy however many Treasury securities are required. So there's this curious circularity in government finance and in fact the real way, in my opinion, to think about the combination of the Federal Reserve and the Treasury is to think about them as one thing. Think about them as one thing and we should publish consolidated statements, the Treasury and the Fed consolidated. What happens in those consolidating statements to the Treasury debt owned by the Fed? It disappears. It's a consolidating elimination. And then we could see net the reality, which is the government is printing out money and spending it. That's the net. And all this other stuff with moving bonds between the Treasury and the Fed is just to fool you. Likewise, we could think of the consolidated government including Fannie Mae and Freddie Mac and the Treasury and the Fed in one consolidated statement. And then the mortgage securities owned by the Fed in this consolidating statement disappear. They're consolidating elimination and what is the reality? The reality is the government is printing out money and using it to fund mortgages to make them cheap to distort housing and land prices. Well, 50 years ago there was a demonstration that central banks can get into a wide series of assets and it's a story that would be fun. I can tell you later, but the end of it was that the Federal Reserve ended up in the 1970s owning bonds, no mortgages, no mortgages, but owning bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Bank of Cooperatives and believe it or not the Federal Reserve in the 70s owned the debt of the Washington D.C. subway system. And there were suggestions that ought to buy the debt of New York City when New York City was about to go bankrupt in 1975. It was very tempting to politicians to use the Fed in this way. Now the Fed fortunately managed, starting in 1978, to get out of this other program of buying these bonds, the liquidation of it lasted until the 1990s, but will the Federal Reserve get out of its vastly bigger mortgage program now? Can we really imagine those mortgages going back to zero? And in some, ladies and gentlemen, we have a Federal Reserve, which is the $8.9 trillion central bank, but it's also the biggest savings and loan in the world, in addition to being the most dangerous financial institution in the world. It's one which does not and cannot know what the results of its own actions will be, and which faces the Cincinnati in problem in the midst of a galloping inflation. And as always, to end today's lecture, with a typical quote from Henry Haslett, that the Federal Reserve goes on, quote, swindling its own people by printing a chronically depreciating paper currency, unquote, and thank you.