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Prepare for a New Banking Regime

NEW YORK ( TheStreet) -- One hundred years later, the Federal Reserve System now may be the single largest, grievously wounded financial entity on the planet. As pent-up stresses unfold, the combined Fed (all of its banks) ultimately may not survive a tough "independent" audit as of Dec. 31, 2013, without a massive equity infusion.

According to its 2012 Annual Report, Federal Reserve banks combined have total "equity" of $54.7 billion compared to total assets of $2.917 trillion. Their ratio of stated equity to assets was, at Dec. 31, 2012, a skimpy 1.88%. By comparison, JPMorgan's (JPM) ratio was 8.05%; Goldman Sachs' (GS) was 8.07%; Citigroup's (C) was 10.24%; Bank of America's (BAC) was 10.72%; and GE Capital's (GE) was 15.32%.

This surface-level comparison does not raise red flags high enough.

Financial statements issued by the Fed are not audited using comparable techniques employed for publicly traded financial institutions. Moreover, these tougher approaches did not catch evident problems before and during the crash of 2008 and 2009. Assets held and liabilities owed by the Fed are not marked to market and not matched in maturity.

Since Dec. 31, 2007, total assets have increased from $847.3 billion to $2.917 trillion -- by 244.3%. During this time period, average yields on 10-Year Treasury securities were 2.94%. By comparison, from 1962 through 1999, yields on 10-Year Treasuries averaged 7.53%.

How large is the implied net markdown on Fed assets and liabilities, assuming benchmark yields settle upward, closer to pre-2000 norms, and that the Fed is forced to match maturities of assets and liabilities more closely?

If the Fed has "hedged" against the risk of sudden increases in benchmark interest rates, what happens to counterparties and to the global system when the Fed comes calling to collect on its hedges?

Profound change will result, as pent-up structural stresses continue now to erupt.

Contours of the Impending Bailout

Though debt securities are easier to understand than equities and commodities, investors have failed to concentrate upon alarming realities in the U.S. debt market, at their great peril.

Unlike September 2008 through May 2013, yields on benchmark 10-Year Treasuries continue to soar as challenges mount throughout the global economy. Put simply, securities issued by the U.S Treasury and core holdings of the Fed are no longer the safest port in the storm.
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