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The world's biggest hedge fund



John Cochrane stole the words out of my mouth—I was planning to write something very similar, but he beat me to it:

The world's largest hedge fund paid $79.3 billion dollars to its main investor last year, as announced to the press and reported by the Wall Street Journal this morning.
It followed classic hedge-fund strategies. It's leveraged about 55 to 1, meaning that for every dollar of capital it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that money to make aggressive bets in long-run government bonds, as well as strong speculative positions in mortgage-backed securities and direct distressed lending. Lately it's been putting bigger bets on loans to Europe and currency swaps. (Balance sheet here.)

The payout was actually conservative, as it reflected only the greater interest payments earned on its portfolio of assets and realized gains, not the substantial unrealized capital gains it made over the last year as long-term bond prices rose.

Who is this miraculous fund? Why our own Federal Reserve of course!

He is absolutely right, and I'll take this opportunity to elaborate. The Fed borrows money by paying for what it buys with bank reserves. The current interest rate on bank reserves is 0.25%, and the Fed decides what that interest rate will be. Imagine having a hedge fund that had virtually no limit on how much it could buy, was not subject to any regulatory scrutiny, and also had the power to determine the rate at which it borrowed money? What a deal. And by the way, this most fantastic hedge fund we call the Fed has already bought close to $3 trillion worth of assets, three times as much as it held in early September 2008. What could possibly go wrong? Unfortunately for those of us in the private sector, the Fed's profits come at our expense, and to the benefit of our government (the Fed hands over its profits to Treasury). And should the Fed end up on the wrong side of rising interest rates, the Fed's losses will be paid for with our taxes and via higher inflation.

At the very least, this is one reason that the world's investors are willing to pay $1700/oz. for gold, an amount that is more than three times the average inflation-adjusted cost of gold over the last century.

I'm not saying that a disaster awaits us, only that there are plenty of reasons these days for investors to be worried about what's going on. And that's why so many things are so cheap.

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