Those in financial circles are likely aware that the above quote is a colloquialism used to highlight that excessive leverage can generate cash flow, but that unless properly and prudently unwound the leverage itself can ultimately lead to financial armageddon. We have witnessed this scenario time and again.

Wall Street specifically, and our economy at large, are continuing to lick their wounds and attempt to recapitalize from the “road to hell” we experienced beginning in 2008. While the financial system as a whole deleverages, Ben Bernanke and his Fed minions have leveraged up in an attempt to ‘ease the pain.’ Just yesterday, Fed officials highlighted that they would continue to leverage up if need be.

In the process, I believe they will simply be moving further
down
that road to
you know where
.

Just how much has the Fed leveraged up? Let’s navigate.

Forbes recently asked, Could a Federal Reserve Bank Go Bust?

Citigroup and Bank of America are not permitted to use such accounting. Market losses on tradable securities hit their balance sheets. The discipline forces commercial banks to do a pretty good job of matching assets and liabilities in interest rate sensitivity. The Fed has no such discipline.

So far this year interest rates have trended down, not up, and the Fed’s profits are robust. Where do the profits go? A $1.6 billion sliver goes to commercial banks as dividends on their shares of stock in the 12 Fed banks. Most of the Fed’s net income goes back to the U.S. Treasury as a fee for the right to issue banknotes.

Like commercial enterprises, the Federal Reserve banks have an equity cushion to cover losses. But not much of one. The system has a Lehman Brothers-style leverage of 55 to 1. At the New York bank, the one that Timothy Geithner used to run, leverage is 104-to-1.

104:1!! YIKES!! Yes, the Federal Reserve Bank of New York is carrying $104 of assets for every $1 of equity capital. Does that sound like a house of cards to you?

We all know that Ben Bernanke and his sidekick Timmy-boy remain the dealers extraordinaire in the shell game that masquerades as our capital markets, but what happens if and when Ben and Timmy lose control. Why do Ben and Tim quake and quiver while the debate on the raising the debt ceiling continues? For the very simple reason that raising the debt ceiling is a necessary function which allows the shell game to continue and is needed to allow the Fed to unwind this leverage. Hopefully.

Make no mistake, though, the shell game and the road to hell are fraught with very real risks. How so?

Until the Great Recession, the Fed limited its purchases of Treasury paper to short-term bills that carry no interest rate risk. The 2008 financial crisis changed that.

The Fed banks began buying risky assets on a large scale: longer-dated Treasury paper and mortgage securities. There’s little credit risk here (the U.S. Treasury stands behind most of the paper), but there is rate risk. When interest rates rise, bond prices go down.

Not to worry, insists Glenn Rudebusch, an economist at the San Francisco Federal Reserve Bank. In a paper published in April he notes that those bonds and mortgage securities are worth more than their purchase prices. The Fed, he proudly recounts, is still gloriously profitable.

Perhaps the Fed is profitable on paper, BUT what if the Fed had to sell their holdings? What if the market value of the Fed’s holdings plummeted and creditors were less willing to provide financing for all those borrowed funds which the Fed needs given its leverage?

But what if inflation shoots up? To restrain it, Bernanke would have to crimp the money supply. To do that he would have to sell some of those securities he’s been buying.

The hitch is that higher inflation means higher interest rates, and higher rates mean falling prices on the Fannie Maes and Treasury bonds. Sales at a loss would eat into the equity capital. To patch up the hole in its balance sheet the Fed would have to beg Congress or the U.S. Treasury for a bailout.

Ron Paul’s worst nightmare.

In this scenario there is no bankruptcy of the sort that has the sheriff carting off the furniture. There would merely be loss of face for the august institution Bernanke runs and a consequent loss of confidence in the dollar.

Says the Shadow Financial Regulatory Committee in a statement critiquing Bernanke’s quantitative easing: “Fed insolvency is not necessarily a low-probability event, and therefore, its consequences for monetary policy and reputation of the Fed are potentially important and worthy of consideration.”

It’s a polite way of saying that there could be a run on the bank. Federal Reserve notes are trust-me money. Do you trust the Fed?

Why do you think the shiny yellow stuff is regularly making new highs? Navigate accordingly.

Larry Doyle is a Wall Street veteran, having worked at such banks as First Boston, Bear Stearns and Union Bank. He blogs at www.senseoncents.com