Fed

Monday, February 01, 2010

Hi All,

I want to use my experience with Equitable Life of New York to explain what transpired in the recent profits made by the Federal Reserve. A big insurance company like Equitable has its assets in two major areas. The first called Separate Accounts is where the investors have their money in things like pension plans. This money is separate from the company and any gains or losses are passed on to the investors. The company makes money by managing these accounts. The second is called the General Fund and this is where the assets that protect the life insurance policies are kept. These monies are invested in conservative things like bonds and mortgages. Back in the 80’s when Equitable received a billion dollars from a French company called AXA they had to place a value on the General Fund to determine how much of the company the billion dollars would buy. The first step was to appraise all the real estate and this was a major undertaking. AXA invested $20 million to have these properties appraised and this leads me to a concept called Mark to Market. At that time it was a common practice for companies like Equitable to hold the value of mortgages on the books at the original price. This meant that if the value of the property increased the value on the books was understated and the reverse. Many large insurance companies took advantage of this by making selected adjustments to the book value of various properties. At that time Equitable had about 60 billion in mortgages on the books and they owed about 58 billion on these which meant they had about 2 billion available to back up their insurance claims. Now they had over 100 billion in outstanding life insurance policies but 2 billion was considered adequate to back these up. The trouble began when some companies would re-appraise properties that they knew had increased in value and up date the book values accordingly. This would increase the amount available to protect the life policies. All of this information was forwarded to insurance rating companies like AM Best and S&P and they used this information to determine the relative strength of the insurance companies. The rating companies could hardly spend 20 million to appraise the Equitable properties and so they had to accept the values given to them. Some companies were not as honest as Equitable and so the ratings given by the rating companies did not have much value. One of the companies that fudged the books on this appraisal process was Mutual of New York and they were rated as triple A, the highest rating available, the week before they went bankrupt.
In an attempt to correct this, the government changed the law and companies had to follow what is called Mark to Market accounting. This meant that all assets had to be held on the books at current market value. This remained the law until the spring of 2009 when the Mark to Market idea was suspended. Recall at that time the banks had lots of bad mortgages on the books and they had to lower the value of those mortgages. Once Mark to Market was suspended the banks could allow the value of those assets to remain on the books at the original value and this helped the bank balance sheet to look better.
The question remains as to how the Fed made $50 billion last year and since no one is allowed to see their books we can only guess what happened and I offer my guess. In a nutshell I think it is all paper profit. The Fed can use money credits from the Treasury and purchase mortgage bundles from the banks and just put a credit on the banks balance sheet and then re-assess the value of these assets higher and put that on their books as profits and then return the money to the Treasury and all this without using any real money.
At this time no one has revealed just how the Fed made all of these profits and I am waiting for their explanation which may not ever come unless the congress demands that they open the books. Don’t hold your breath.

Jack (John) Novick