The Fed is Dead.

For all intent and purpose the Federal Reserve is bankrupt.

There are two banking systems in existence today. The Traditional Banking System – i.e. High Street banks and the Shadow Banking System. But both systems overlap because, the major banks of the traditional system helped create the shadow banking system. In fact they are the key players in the use of the so-called "new financial products, the CDOs, CLOs, MBS" etc and which have now turned toxic – worthless, junk to be exact.

The first public mention, to my knowledge, of the shadow banking system by anyone of any public authority occurred on March 3rd, 2009 by British Prime Minister Gordon Brown.

Prime Minister Gordon Brown’s remarks at the White House, March 3, 2009:

“Well, there's got to be deep regulatory change. We've just been talking, Barack and I, about the need for proper supervision of shadow banking systems, of areas where there was bank practices that were unacceptable, where remuneration policies got out of hand and weren't based on long-term success, but on short-term deals. And these are the changes that we've already announced that we are going to make.”

“We've had a global banking failure, and it's happened in every part of the world. It's almost like a power cut that went right across the financial system. And we have got to rebuild that financial system. We've got to isolate the bad assets.”

“You don't want shadow banking systems. You don't want regulatory tax havens. So we've got to act as a world together to deal with that. And that's one of the things we'll be talking about in April in London.”

Even if he meant it, it is too late.

The idea of a central bank going bankrupt is not out of the realm of possibilities. What underlies this crisis is the potential collapse of the global banking system, specifically the Shadow banking system.

Nouriel Roubini, the New York University professor said:

"The process of socializing the private losses from this crisis has moved many of the liabilities of the private sector onto the books of the sovereign. At some point a sovereign bank may crack, in which case, the ability of the government to credibly commit to act as a backstop for the financial system – including deposit guarantees – could come unglued."

"Sovereign bank" means central bank. When a central bank "cracks" it becomes insolvent. If the Sovereign bank becomes insolvent any government guarantees will ring hollow and will be useless.

The only issue is the extent of the damage to the global economy and how long it will take for the world to recover from this financial madness that has no precedent.

To give a small sampling of the 4th quarter mess here are the banks' quarterly financial reports as of Dec. 31:

— J.P. Morgan had potential current derivatives losses of $241.2 billion, outstripping its $144 billion in reserves, and future exposure of $299 billion.

— Citibank had potential current losses of $140.3 billion, exceeding its $108 billion in reserves, and future losses of $161.2 billion.

— Bank of America reported $80.4 billion in current exposure, below its $122.4 billion reserve, but $218 billion in total exposure.

— HSBC Bank USA had current potential losses of $62 billion, more than triple its reserves, and potential total exposure of $95 billion.

— San Francisco-based Wells Fargo, which agreed to take over Charlotte-based Wachovia in October, reported current potential losses totaling nearly $64 billion, below the banks' combined reserves of $104 billion, but total future risks of about $109 billion.

These numbers are bad but are completely missing the heart of the problem: The Repurchase market.

The repurchase market is the link that joined the two banking systems together.

As such, it is the weakest link in the entire financial system.

The repurchase market is a very very complex organism that I am only beginning to wrap my head around. To use an analogy, cash and cash flow is the life blood of the economy and the Repurchase market is the heart that keeps pumping it through the system. It is the market where all financial institutions (regulated and unregulated) go to obtain financing to meet reserve requirements, bridging finance, to lend or purchase securities, to hedge and or to invest on short-term basis.

I will work on another post to explain the nature of this market but for now I will leave it at that.

The repurchase market before the crisis was estimated to be worth around $12 trillion as compared to the total assets in the entire US banking system of $10 trillion.

With the collapse of Bear Stearns what we were effectively witnessing was a run on the repurchase market as observed by Tim Geithner in 2008:

"The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets.

"This parallel system financed some of these very assets on a very short term basis in the bilateral or tri-party repo markets. As the volume of activity in repo markets grew, the variety of assets financed in this manner expanded beyond the most highly liquid securities to include less liquid securities, as well. Nonetheless, these assets were assumed to be readily sellable at fair values, in part because assets with similar credit ratings had generally been tradable during past periods of financial stress. And the liquidity supporting them was assumed to be continuous and essentially frictionless, because it had been so for a long time.

"The scale of long term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type run, but without the protection such as deposit insurance that the banking system has in place to reduce such risks."

And Bernanke said:

"We have been working with market participants to develop a contingency plan should there ever occur a loss of confidence in either of the two clearing banks that facilitate the settlement of tri-party repos."

Louis Crandall, economist at Wrightson ICAP observed:

"The vulnerability of the tri-party repo system has been a recurring theme among Federal Reserve and Treasury officials in recent weeks."

Panic swept across the entire repurchase market.

No securities were considered safe enough for repurchases except US treasuries.

Fundings in the repurchase market ground to a halt.

Market players withdrew funds and began hoarding treasuries.

Treasury interest rates actually reached a point where they were being bought at a negative interest rate they were so desirable.

To quote Gary Gorton:

"Imagine a firm that is levered 30:1, by borrowing in the repurchase market. If the haircut doubles, or goes from zero to a positive amount, the required deleveraging is massive! Most investment banks were levered 30:1, equivalent to about a 3 per cent haircut. If the haircut rises to 6 per cent, at least half the assets will have to be sold.

"Another sign of trouble is a ‘repo fail’. A ‘repo fail’ occurs when one side of the agreement fails to abide by the contract. [Fail to deliver the security under the repurchase agreement.]

"Dealer banks would not accept collateral because they rightly believed that if they had to seize the collateral should the counter-party fail, then there would be no market in which to sell it. This was due to the absence of buyers because of the deleveraging. This led to an absence of prices for these securities. If the value cannot be determined because there is no market – no liquidity or there is the concern that if the asset is seized by the lender, it will not be saleable at all, then the dealer will not engage in repo. Repo dealers report that there was uncertainty about whether to believe the ratings on these structured products, and in a very fast moving environment, the response was to pull back from accepting anything structured. If no one would accept structured products for repo, then these bonds could not be traded – and then no one would want to accept them in repo transactions."

The Fed intervened aggressively to check the run on the repurchase market by the creation of the Primary Dealer Credit Facility (PDCF). Various measures were taken, but the Fed was willing to accept and secure funding of the players in the repurchase market. The Fed also intervened by lending a huge chunk of its US treasuries in exchange for junk securities to facilitate credit expansion.

The result and where we are now: The Fed’s present balance sheet of approximately $2 trillion is made up mostly of junk securities.

If you found out your bank's balance sheet is made up of junk and not backed by real assets, what would you do?

But of course, one can argue that the Fed is not your bank. It is the central bank of the all powerful USA. It will always be able to "print money" or "digitalise" money and keep the markets going.

But the Federal Reserve Note is mere paper, fiat money which cannot be redeemed for anything tangible such as gold.

When Joe Six-Pack realizes that the Federal Reserve Note is not even secured by US treasuries and or the FED has real tangible assets, but its balance sheet is littered with junks and toxic waste, there will be a run on the Fed.

In other words, when Americans and foreigners no longer have faith in the Federal Reserve Notes as "money".