It's a bold assertion, not a click trap title. The Federal Reserve Bank is bankrupt. It wears the facade of solvency offered by simple creative accounting. A company goes bankrupt when it piles up losses that wipes out its capital and reserves. When this happens to some big corporations, it makes headlines. This is happening to the Fed but we can hear a pin drop in the silence.
To make the article digestible, I economise on the details and use broad strokes as much as possible.
First, some background on the Fed. It is not owned by the government, but an independent entity. It was created by the Federal Reserve Act 1913, tasking it with operating the US reserve banking system and managing the monetary policy to maintain full employment and price stability (i.e. inflation). The country is split into 12 districts with a Federal Reserve Bank in each district known as District Banks. Collectively we call them the Fed for short. The shareholders of the District banks are the various commercial and mutual trust banks operating in the respective districts. A Board of Governors oversees the running of the Fed. Members elect their representatives to the Board, except for the Chairman who is nominated by the US President. The Chair does not report to the President.
The District Banks are not for-profit entities and its operating financial is basically :
LESS: Interest expenses
Net interest
LESS: Operating overheads
Net income
Interest revenue comes from its SOMA portfolio and in their lender of last resort activities. SOMA (Securities from Open Market Account) are the fix-rated securities the Fed purchases in the QE (Quantitative Easing) and sells in QT (Quantitative Tightening). Lender of last resort is very short term (mostly overnight) to supply liquidity to the money market and is basically reverse repo (these are securities purchased with a resell commitment, often overnight, under a Repurchase Agreement).
Interest expenses is the interest the Fed pays to banks for balances on their Reserve Accounts. These are cash deposits commercial banks, by regulation, have to place with the Fed for liquidity purposes to prevent bank runs. In addition to this, the Fed has to pay for its funding cost for the reverse repos. The Fed pays at market rates.
By Law, the earnings are distributed firstly by dividends of 6% to shareholder banks.The dividends are cumulative. The payout to the larger shareholders
have been revised and reduced to less than 6% fluctuating in accordance with a
formula. The remaining balance, 10% goes to a surplus capital account and 90% to the government Treasury. The surplus was supposed to build to 100% of paid up capital, but has been revised down to US$6.875B which has by now been reached.
Shareholder banks have a liability of absorbing the Fed's losses up to 2 times the amount of their stock holdings.
The Fed's annual operating expenses is estimated at US$9B. It thus needs to generate net interest in excess of this sum to turn a profit which it has consistently managed to do in the past purely on its reverse repo transactions. With huge balance sheet built up in recent years, its massive SOMA portfolio enabled Fed net interest income to increase substantially since 2009.
All investors who are unhedged in a leveraged long fix-rated assets worry about their interest rate mis-match risk. A rise in interest rates means their cost of funds increases, and net interest deteroriates. It's a rate risk they carry that can bury them. But the Fed is not a normal entity and has absolutely no worries about their net interest line. What makes them a different animal? The fact is, the Fed acquires their securities in their QE exercise by printing money. They have no carry cost to worry about.
We call QE printing money because the Fed purchases securities and pays for them by simply crediting the sellers' banks reserve account. This way the Fed pours money into the market hoping the increased liquidity will stimulate the economy.
The big problem this massive SOMA portfolio presents is its valuation. The securities are fix-rated. The price of these securities move inversely with market interest rates. When interest rates fall, the prices of fix-rated securities rises and valuation increases, registering unrealised gains. Inversely, when interest rates rise, the prices of these securities falls and valuation decreases, causing unrealised losses.
Let's use the Fed rates to approximate market rates. The Fed started to increase interest rates in Jan 2021. As at 31 Dec 2021, Fed financials show it was sitting on unrealised gains of US$128B. By 31 Mar 2022 its securities valuation had turned into unrealised losses of US$330B. This means in Q1 when rates started rising, the losses registered was US$458B. The expectation is for the Fed rate to hit 2.75% by year end, so valuation losses could possibly hit US$1T for full year 2022.
The Fed's paid-up capital currently is US$35B. Add the US$7B surplus its Equity is US$42B. The Federal Reserve Act requires shareholder banks to absorb losses but limited to 2 times their stock holdings. This means there is a contingent capital of US$70B to fall on. The Q1 valuation loss of US$456B has totally wiped off the equity of the Fed, including the contingent capital. Any other company would be as dead as the dodo bird under the circumstances, but no, not the Fed.
The only way out is to cheat. Under IFRS and GAAP (international and American accounting standards), all financial institutions have to provide for valuation losses of financial instruments that can be marked-to-market. The Board has chosen, in contravention of legislation and accounting standards, not to recognise unrealised valuation gains and losses. Its capital will thus remain intact in financial statements. The unrealised losses are put on "deferred" status, on the rationale it will be cancelled out when interest rates fall in the future. They are taking the very long term investment return view. Have we not heard of this before, in Temasek's financial reports, whenever the ROI for the current year sucks.
As the Fed manages price stability, it would be constantly doing QE or QT and increasing or reducing Fed rates as it fine tunes market liquidity. Hence under normal circumstances, its SOMA portfolio would be a process of building up and liquidations. It follows therefore that unrealised gains or losses will more or less square off and "differing" unrealised valuation lossess/gains is reasonably justifiable. However, the fact shows that since 2009, it has been unable to reduce balance sheet size. What confidence is there that at US$8.8T it is able to do so now?
Over time, if interest rates do not fall to a level that will neutralise the valuation losses, there is the inevitability of the losses being realised when the securities are sold or matured. Thus the situation is dependent on (1) the Fed's decision to use QT to fight inflation and (2) the ageing, or maturity profile of the SOMA portfolio. The Fed has not yet started QT, but it has indicated that it will shrink balance sheet by US$30B a month.
Will this unrealised losses have a play on the monetary policy decisions of the Fed? Think about this. Raise interest rates (which tightens liquidity) -- and get hit with increased valuation losses but which won't impact Fed net income since unrealised losses are not recognised. Or do QT (tighten liquidity by selling securities) and get hit by realised valuation losses. The governors sitting in the Board also run their own commercial banks. Will they vote for QT to get their banks to absorb Fed realised losses?
Read : Why the US which has a US$30.5T public debt, has no reserves, but it will never go bankrupt, technically.On maturity of the securities, if interest rates have not fallen back to 31 Dec 2021 levels, the valuation losses will be realised. This is inevitable. So the question is how long will interest rates remain at current levels and in fact, will it rise further? This depends on the economy.
If inflation, the tools are QT and rate increases. Both Fed Chair Jerome Powell and Treasury Secretary Janet Yellen have said the inflation is transitory but have since taken this back. It now seems it will be a long inflation. Powell has said he is dead serious on fighting inflation. With inflation now at 8.6%, some says the Fed has done too little too late. A Volcker style massive increase in interest rates may be necessary to tame the beast. Yet others say, it's too late. The horse has already bolted. The economy is already in recession.
If recession, the tools are QE and reduce interest rates, thereby increasing liquidity to stimulate the economy.
Both the Purchasing Managers' Index and the Consumer Confidence Index that came out recently, showed low market expectation. Yet last week, all market indexes, including crypto, rebounded and made some recovery. This could well be due to Powell's presentation at Congress where he indicated the Fed is still fixed on possibility of achieving 5-10 year long term inflation of 2%. In the Consumer Confidence Index, market expectation is an inflation of 3.1%. Investors are not worried of 2% or 3% inflation. That's probably what drove the market up last week. Which suggests the market was driven by a longer term view and ignored the short term reality. But is that what other data points are indicating? A critical data is the employment levels. Unemployment claims were up slightly, indicating a slide into recession.
This digression into inflation is just to show that there is no clear path to how the huge unrealised valuation losses can be resolved.
Now let's do some thought experiment. When securities mature, valuation losses are realised. The government as issuer, must now pay the Fed at face value of the securities. The Treasury is broke. It issues new securities and use the proceeds to redeem the matured securities from Fed. The government rolls over the debt. The can is kicked further down the road. But what happens if the US government securities are no longer in demand?
Any ordinary investor would be forced to write off a bad debt if there is no way to recover it. But the Fed is no ordinary investor. The government has defaulted on the securities redemption. It now owes the Fed. Normal accounting standard requires the Fed to write off the bad debt (unless the Fed seeks to take over some fighter jets or aircraft carriers, etc). But the fact is the Fed never funded the acquisition of the securities in the first place. They merely printed money for it. So how can the Fed have valuation losses or write off losses? On the other hand, the Treasury received cash for the securities it issued and must now redeem them on maturity.
There is a joke about accounting being the only profession where creativity can land one in prison. The Fed now requires some creative accountants to solve the accounting mess in the ledgers of the Treasury and itself to clear these matured but un-redeemed securities and valuation losses. Fiat currency sure seems like magic money or some ponzi scheme from central bankers' point of view.. However one looks at it, if the Fed is a casino, the house is broke.
