Market and Liquidity Risk in the Federal Reserve System: Are We Headed for Fiscal Oblivion?
The rules governing the Federal Reserve Banks and the Board of
Governors are available for public perusal, so this isn't a scandal
or a conspiracy missive. It's meant to provoke thought, and to
highlight the market and liquidity risks that reside in our
monetary authority. The Federal Reserve -- know as "the Fed" -- is
currently led by Ben Bernanke. Mr. Bernanke got the nickname
"Helicopter Ben" by claiming that the Fed could flood the money
supply to stave off deflation in a depression, and in 2008, he
proceeded to follow his own advice. Since then, we have seen an
unprecedented intervention in our financial markets, and there have
been claims that we're headed for fiscal oblivion. This article
attempts to evaluate that risk.
And, to be fair, I'm still not sure if this analysis is correct, but here goes.
I analyzed the balance sheet and income statement of the Fed. As with any risk management exercise, I looked at it with skepticism, questioning the assumptions, asking, " Why? " and also asking, " What if ?"
Some of my questions:
- Why does the Fed get to set its own accounting rules?
- What if those special accounting rules were not there?
- What if the Fed followed the same accounting rules that other banks follow?
- What if interest rates rose from 2% to 6% and the Fed was subject to mark-to-market accounting?
The Federal Reserve is not a singular bank at all. In fact, it is a collection of banks, run by the Board of Governors. The Board of Governors is a government agency, and Ben Bernanke is the Chairman of this Board. There are 12 district banks and they're each independent companies, owned by the commercial banks in each region. When a deposit-taking institution gets approved to be a bank, it becomes a "member bank" and is required to purchase equity capital of its Federal Reserve district bank. Currently, one-half of this capital is paid in , and the remainder is "subject to call." In other words, the Board can require the member banks to pay more capital into the system if the central bank's capital gets too low (my assumption). So, in reality, banks like Bank of America Corp ( BAC ), Citigroup Inc ( C ), and JPMorgan Chase & Co. ( JPM ) are the last line of defense to bail out the Fed if its own capital gets too low. (Read that sentence again - didn't you think it would be the opposite?)
The Fed's Capital Base
Since we are all accustomed to thinking of the Fed as the entity that controls interest rates and monetary policy, the underlying structure of the central bank can easily be overlooked. The Fed system is a bank. Indeed, it is the central bank, but it is first and foremost a bank (or a collection of banks, but for simplicity, let's just assume it is a single bank, and we'll call it the "Fed"). The central bank was authorized by Congress in the Federal Reserve Act of 1913 - 12 USC 226. In addition to buying shares in the Fed, the member banks put funds "on deposit" -- sort of like you and I do at our corner bank. The Fed recognizes these deposits as liabilities, and it uses these funds to purchase assets, like US Treasury bonds. Another way the Fed incurs liabilities is by printing currency, or Federal Reserve Notes (look at the top of any dollar bill). The Fed prints money, and recognizes that currency as a liability. These two tools -- contributions from member banks (capital, deposits) and currency printing -- are the primary means that the Fed uses to acquire assets. Like any bank, the Fed has a balance sheet, listing its assets, liabilities, and capital. Unlike any other bank, the Fed remits its excess earnings back to the US Treasury. Last year, the Fed sent $88 billion back to Uncle Sam.
As set out in the "Federal Reserve Act":
The net earnings derived by the United States from Federal Reserve banks shall, in the discretion of the Secretary, be used to supplement the gold reserve held against outstanding United States notes, or shall be applied to the reduction of the outstanding bonded indebtedness of the United States under regulations to be prescribed by the Secretary of the Treasury. Should a Federal Reserve bank be dissolved or go into liquidation, any surplus remaining, after the payment of all debts, dividend requirements as hereinbefore provided, and the par value of the stock, shall be paid to and become the property of the United States and shall be similarly applied.
And that's when I asked, "What if?" and "Why?"
What if there is a loss , not earnings? And why did Congress make mention of liquidating a Federal Reserve Bank in the 1913 Act? What if a liquidation really happened? And what if a district Reserve Bank is liquidated, but there is a deficit, not a surplus?
To the first question, I found a quick response: If the earnings are not sufficient, the payments to the Treasury are suspended. As for the additional questions, one would consult corporate bankruptcy laws as a guide. Unfortunately, the major unsecured creditors in the case of a bankrupt Reserve Bank would be those same member banks that have deposits on hand at the Fed. So if the Fed goes under, the whole banking system apparently collapses. Good heavens! We better make sure that there are always earnings at the Fed, and we better make sure that there is no liquidation of a reserve bank. (Hmm…)
No other institution gets to define its own accounting policy - only the Fed gets to do this. "The Board of Governors has developed specialized accounting principles that it considers to be appropriate for the nature and function of a central bank," states the Fed website .
Now this is where things get fun. The Fed sets its own accounting rules, and they're different from the rules it makes other banks adhere to. That's scary, especially when you think that its balance sheet eclipses $3 trillion. SOMA (System Open Market Account) are the type of bonds that the Fed buys to control the money supply. You may have heard of QE, QEII,QEIII, tapering down, etc. These are all terms dealing with the Fed's main asset: US Treasury bonds. Now, any professional investor who buys bonds has to account for them using fair market value, and that value swings up and down with changes in interest rates. But not SOMA; they get to carry these $2 trillion at "amortized cost."
Following is an explanation from the Fed's annual report -- and it kind of reads like an inverse version of an Enron disclosure.
Amortized cost more appropriately reflects the Reserve Banks' securities holdings given … (their) unique responsibility to conduct monetary policy.... Decisions regarding securities… transactions… are motivated by monetary policy objectives rather than profit.
As I mentioned in the introduction, this isn't a conspiracy paper, and all this information is reported - even the difference between fair value and cost is reported (it is about a $214 billion gain in the Fed's last statement). Oh, by the way, that $200 billion is four times the capital base of the Fed ($54 billion is their "equity"). Yes, in banking parlance, the Fed is "thinly capitalized." What! How thinly capitalized? Very. For example, when hedge funds gear up 20:1, the Fed goes nuts, calls it a systemic risk, etc. But the Fed is currently leveraged almost 60:1 - and that's on an enormous balance sheet, all of which is conveniently shielded from market valuation. Indeed, the Fed may be the largest hedge fund in the world, and it is running its books on accrual accounting!
Let's take the analysis one step further. In the world of corporate accounting, both assets and liabilities are subject to fair market value accounting. In the case of the Fed, its two largest liabilities are the cash in circulation -- "Federal Reserve Notes" -- and deposits of member banks - neither of which have a market value that is sensitive to interest rate changes. So, in theory, if the market value of the Fed's assets declines, with a rise in rates, its liabilities stay the same. And according to basic accounting, that means the capital goes to zero, or becomes negative. When real-world companies get too negative in their capital accounts, they run the risk of bankruptcy. However, since no one wants to say that the Fed could indeed go bust due to interest rate risk, we ignore the accounting. If any other bank did this, it would be immediately shut down by the Fed.
Now, to be fair, the Fed also records its gold at amortized cost, or about $42 per ounce, so there are some unrealized gains that could offset the decline in value of assets due to Treasury bonds with rising rates - but we long ago eclipsed the value of gold holdings in our currency circulation.
Negative Earnings at the Fed
As illustrated above, the Federal Reserve Act only addresses the division of earnings back to the US Treasury. There is no discussion of the allocation of losses. One can only assume that the Congress in 1913 believed that the Fed would never have losses, because the Act is explicitly silent on the matter. The closest I could find to loss-forecasting is that the Fed is entitled to suspend its interest payments back to the Treasury. In other words, the Fed would be allowed to "stiff" the Treasury, and could enter a period where the interest due on Federal Reserve Notes sits as an unpaid liability. Granted, this expense would be legally "suspended" until there were earnings, but in any other commercial setting, this would be considered a default.
Most academics assume that the Fed's liability to the Treasury doesn't even matter, and maybe it doesn't. But what if it does? What if the Treasury really needed the funds because it was running serious fiscal deficits and/or owed interest payments to the US Treasury bondholders? Fed's response: "That's not my problem." Rather, the Fed could just print more money, and buy more US Treasuries - i.e., debt monetization.
What If the Value of the Fed's Treasury Bonds Plummets in Value?
Let's suggest an optimistic scenario: The economy starts to sizzle, causing rates and inflation to rise, and the Fed decides it wants to rein in the money supply. In this case, the Fed may be forced to sell its assets on the open market. But since the value of those US Treasury bonds has fallen, the Fed would be unable to soak up as much cash as it generated when it bought the bonds in the first place. Thus, the mark-to-market loss would become a realized loss, and it would take the shape of excess money supply that the Fed would want to absorb, but could not absorb because the assets it is selling are too low in value.
One rebuttal to this scenario that I have heard is that the Fed could just wait until the bonds mature. That's true, but it also implies that the Fed would be lacking a tool it commonly uses to soak up all that cash that fell from Ben's helicopter. So let's look for alternatives. The assets that are not funded by cash in circulation are funded by the deposits of member banks at the Fed, so the Fed could try to increase those deposits. However, if the economy is sizzling, it seems logical that the banks with funds on deposit would want some of their deposits back, right? You see, banks need these deposits to make loans to everyday businesses and people. So it isn't inconceivable that at the same time the Fed wants to reduce the money supply, it would be feeling pressure to send cash back to its depositors (the member banks). The Fed could always send money back to depositors by printing more Federal Reserve Notes, but remember that this scenario began with a goal of reducing the money supply, not expanding it. The Fed would seem to be in a pickle, forced to expand the money supply at the same time it is trying to reduce it - like a leaky faucet. In this contrived scenario, the other action the Fed can take is to raise the reserve requirements of the member banks, thereby offsetting the expansion of the money supply and, unfortunately, running the risk of creating a credit crunch. Remember that it was a credit crunch that originally got us in this mess back in 2007-2008. In sum, it seems like there would be two unpleasant alternatives:
- Print money (inflation, debt monetization).
- Force the member banks to pay up more capital (credit crunch, liquidity squeeze).
Given the above risk, it makes sense that the Fed completely ignores the market risk in its accounts. To try to recognize the scale of this risk means acknowledging that it could bring down the entire financial system - much better to place our heads firmly in the sand. And remember, the Fed's bond portfolio is $2 trillion - that is bigger than Fannie ( FNMA ) and Freddie ( FMCC ) combined, it is 15% of our GDP, it's a huge number. Today, the Fed's accounts simply ignore the risk. And we know that ignoring the risk does not make the risk disappear.
Risk managers envision remote scenarios to see where the bumps in the road might be. From this analysis, it seems that we may have reached an economy that cannot grow too fast, or it runs the risk of compromising the tools the Fed uses to control money supply. I have coined this situation the Bernanke Covered Call, because the Fed has sold tomorrow's upside in return for saving our skins today. And as a result, future economic growth may threaten the Fed's ability to control inflation, pushing it toward creating a new credit crunch or a new recession.
Editor's note: Edward Hoofnagle , CFA, founded and sold a variety of companies in the technology and consulting industry, and currently manages an investment portfolio of private companies. Ed also provides business advisory services and offers interactive seminars for entrepreneurs and family offices related to financial literacy and charitable planning.