THE FLOOD IS COMING (AKA, BUILD YOUR ARK WHILE THE LAND IS STILL DRY)

This Bloomberg piece (H/T Ritholtz) highlights a very important issue: the changing (read: declining) composition of the Federal Reserve's balance sheet. The ostensible gist of the story is revolting enough, dealing as it does with the true state of what the Fed took on last year when it brokered the Bear Stears-JPMorgan Chase deal -- mostly California & Florida-based mortage holdings. But taking it to a deeper level, it makes us focus on a far-greater problem: the fact that the Fed has not only doubled the size of its balance sheet, but that much of this expansion has come in the form not of U.S. Treasuries, but with the very "toxic assets" that we've come to know as a root cause of the financial downturn. A few highlights, then I'll try to sum it up at the end:

The Federal Reserve released its most detailed breakdown to date on the types of assets it accepted from Bear Stearns Cos. a year ago and the cause of losses on the portfolio. The biggest losses in the $25.7 billion portfolio of Bear Stearns assets as of the end of last year came from commercial and residential mortgages, according to a report released by the Fed in Washington today. The central bank agreed in March 2008 to buy the assets so JPMorgan Chase & Co. would acquire Bear Stearns and avert the investment bank’s bankruptcy.

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The Fed wrote down the value of former Bear Stearns commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said today. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.

“It’s just the tip of the iceberg when it comes to losses in the commercial real estate market,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. Lenders “were over-optimistic about tenant occupancy rates and rents,” he said.

The emergency action to prevent the collapse of Bear Stearns started the Fed on an unprecedented path, which has led the central bank to more than double the size of its balance sheet. Bernanke has overseen an expansion of its efforts to include financing corporate debt, lending to securities dealers and the commitment to buy hundreds of billions of dollars of mortgage securities and Treasuries.

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Today’s releases from the Fed also included information on its holdings of assets accepted from AIG, which reflect less of a change because of the shorter period that the central bank has owned the portfolios. The AIG rescue dated from September. Maiden Lane II LLC, formed to buy residential mortgage-backed securities from AIG, included subprime-loan assets valued at $10.8 billion and “Alt-A” or adjustable-rate loans valued at $5.23 billion as of Dec. 31. Maiden Lane III LLC was formed to buy from AIG collateralized debt obligations linked with residential and commercial mortgage securities. One-third of the $26.7 billion of CDOs in the portfolio have ratings below investment grade, the Fed report showed today.

AIG said last month that Societe Generale of France and Deutsche Bank AG of Germany led a group of 20 foreign and U.S. banks that received $22.4 billion in collateral payments after the Fed’s rescue.

Also in September, the Fed declined to rescue Lehman Brothers Holdings Inc., saying the firm lacked acceptable collateral for it to justify extraordinary aid.

Remember, by the way, that Geithner was involved in this decision. I'm not saying we should have rescued Lehman in exchange for its worthless assets. We shouldn't have. I just wonder what rationale existed to justify saving certain banks and institutions (with strong ties to Goldman Sachs & JPMorgan Chase) while letting others die. Anyhow, back to the piece:

The Bear Stearns holdings show new detail on the type of assets that JPMorgan didn’t want to accept as part of its takeover of Bear Stearns. The total amount of losses on the Bear Stearns holdings was previously disclosed by the Fed in January. The Fed said its commercial-mortgage loans had principal of $8.5 billion at the end of December, compared with the “fair value” assessment of $5.6 billion, indicating an assumption that about 35 percent of the debt won’t be paid back.

Keep in mind, that this article focuses on one very small part of the increase in the Feds balance sheet. There are hundreds of billions more.

The Fed has nothing to back its Federal Reserve Notes (what we call "dollar bills") except the full faith and credit of the United States government. And the United States government is deeply in debt, unable to pay its bills or its creditors unless it borrows ever more money. The world knows this, of course, which is why foreign governments -- like China -- have been buying far less US debt lately.

So where will the Treasury get the money to pay its bills and creditors? From the Federal Reserve of course! And where will the Fed get the money to lend to the Treasury? From thin air of course!

Now we begin to get deeper into the soup. Because traditionally, what does the Fed do to sop up all that newly-printed money it injected into the economic stream? In other words, how does it prevent this monetary inflation (known, simply, as "inflation" by economists I respect) from translating into general price inflation? How does it curb this massive increase in the adjusted monetary base (aka, the Fed's balance sheet)? Well, under normal circumstances it would unload from its balance sheet, selling the treasuries it has purchased back into the economy . . . thereby re-absorbing those newly-printed dollars.

But now folks, we come to Hamlet's proverbial "rub." Because -- based on the realities of April 2009 -- who the hell is gonna buy those treasuries? The very same treasuries the Fed had to buy because no one else wants them. Will the Chinese buy treasuries from the Fed that they wouldn't buy from the Treasury? They prefer Bernanke's well-trimmed beard to Timmy's shifty eyes? No.

And, even more importantly, over the last six or eight months, the Fed has already printed -- and given to the largest banks and Wall St. institutions -- enormous amounts of money . . . in exchange for all the garbage now parked on its own balance sheet. How on earth can it sop up that money? Who will buy back all the shit assets and toxic loans that caused the entire debacle in the first place?

This, folks, is the big question. The biggest we have. Because the very frightening bottom line is that the banks -- the banks who have received billions if not trillions in governmental largesse -- are sitting on a lot of money. And when they start lending it out -- and they will, because that's the only way they make money, other than via bailouts -- there's gonna be a lot of money flooding the economy. Flooding an economy in serious trouble, with decreased demand, low employment, high debt, bad credit ratings, and lots of fear.

Meaning prices will skyrocket. For all the things that we must spend that new money on: food, fuel, medical care, rent, insurance. The cost of living will become unmanageable ovenight.

And the Fed will be powerless to do anything about it, because it will have nothing of value to sell to remove that flood of money from the general economy.

Price inflation is coming, it's just a matter of when. Protect yourself . . . any way you know how.