Time to listen to Ron Paul and audit the Fed? 

Republican presidential candidate Ron Paul’s bill requiring a full audit of Federal Reserve System banks before the end of 2012 might not be as wacky as some people think, especially if, as Robert Romano writes, the Fed itself may be teetering on the brink of insolvency.

Romano quotes Euro Pacific Capital chief economist Michael Pento:

“Prior to the bursting of the credit bubble, the public was shocked to learn that our biggest investment banks were levered 30 to 1. When asset values fell, those banks were quickly wiped out. But now the Fed is holding many of the same types of assets and is levered 51 to 1! If the value of their portfolio were to fall by just 2% the Fed itself would be wiped out.”

What same types of assets, you may be wondering?

 “The Fed has just $52.5 billion of capital to back its $2.7 trillion balance sheet, an equity cushion of just 2 percent,” Pento writes. “Over $917 billion of that balance sheet is in mortgage-backed securities…”

Mortgage-based securities! The same paper that helped crash the housing market and then tanked the entire U.S. economy? And with still-declining home prices in most U.S markets, still a lousy investment?

Yup. In fact, Pento says, the Fed now holds more mortgage-backed securities than the total of its entire balance sheet before the 2008 housing crash.

And because of the Fed’s policy of booking losses as Treasury liabilities, U.S. taxpayers are on the hook if the central bank ever goes belly-up.

Because of this “accounting trick,” Romano points out, “The Fed can still sell all the mortgage paper it wants for less than it purchased them — without any seeming consequences to its bottom line.”

The current set-up, Pento concurs, “would make Enron jealous.”

But all good scams eventually come to an end. Pento argues that the Fed has two choices going forward, none of them good:

“If financial institutions were forced to pay par for the Fed's mortgage assets, [Chairman Ben] Bernanke would destroy a great deal of their capital and a new breed of zombie banks would re-emerge. … If the assets are sold at the fair market price (which will likely be far below what the Fed paid), Bernanke would burn through his balance sheet before all of the prior Fed liquidity injections were neutralized.”

The upshot for U.S. taxpayers?

“There are many political and economic reasons why the Fed will find it extremely difficult to absorb the liquidity that it has relentlessly pumped into the economy since the beginning of the financial crisis,” Pento writes. “But its biggest problem may be that the ammunition it carries on its balance sheet is insufficient to the task….

“Given what is has on hand, the Fed will be unable to raise interest rates and support the currency. In essence, they have become impotent in removing the inflation they have so diligently created.”

Given that the Fed is already more unpopular than the IRS, how hard will it be to find the political will to take Ron Paul’s advice?

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