In ordinary times it would be ignorant to ask, “Who’s going to bail out the Fed?” — but then again these aren’t ordinary times.
Solvency of the Federal Reserve Bank shouldn’t be an issue because it carries the full faith and credit of the United States of America. In theory, the only way the Fed could need a bailout is if the federal government fails.
While theory is interesting, political reality is an entirely different story. The Federal Reserve is putting its future at risk by ignoring its own likely financial results when it raises interest rates. Simply put, rising interest rates will hurt the Fed by making interest costs higher and asset values lower.
Congress has gotten used to spending profits made by the Fed. Based upon first quarter results the Fed is on track to turn over more than $110 billion in 2011.But what happens if the Fed’s profits suddenly turn to losses? Will Washington remember the Fed’s enormous earnings and cut them some slack?
In the mafia, you are only as good as your last envelope. Congress works in much the same way. It’s a sure bet that Congressional memory won’t last more than a single missed payment. When the Fed stops kicking up to its Congressional bosses, it’s future will be in serious jeopardy.
While the Fed isn’t like any other bank in America, it is still subject to the immutable rules of math and interest rate risk. If the Fed starts to earn less on its investments than it pays in interest on its deposits, it will lose money.
That is exactly what the Fed is facing when interest rates rise — that it will pay more for deposits than it earns on its investments.
Taken in isolation the Fed’s balance sheet looks more like an overleveraged hedge fund than a shining example of prudent risk management. The Fed has almost no capital to back up its big macro bet on interest rates and the shape of the yield curve. Higher interest rates or an inverted yield curve where long-term assets yield less than short-term assets will cause problems.
The Fed borrows money by accepting short-term floating rate deposits from banks. It uses its cash to purchase mostly long-term fixed rate bonds. Through the monetary stimulus programs of QE I and QE II the Fed has purchased a boat load of long-term fixed rate bonds and now owns approximately $2.3 trillion of these assets.
When short-term interest rates increase the positive difference between what the Fed earns on its investments over what it pays to borrow money will shrink. If interest rates rise enough, the Fed will start booking losses.
A simple stress test on the Fed suggests that an increase of between 3.00% and 3.50% in the federal funds rate will turn the Fed into a text book example of a Congressional basket case. For the vast majority of the Fed’s existence, the Federal Funds rate was above its breakeven point of around 3.25%.
Even worse, the Fed’s assets, Treasury bonds and mortgage-backed securities, will fall in value when interest rates go up. It is a universal bond truth that when interest rates rise, the market value of fixed rate investments falls. Falling market values will restrict is ability to trade into higher yielding assets without realizing market value losses.
Unlike all other banks, the Fed has essentially no equity to absorb losses. It is required by law to transfer the vast majority of its profits to the Treasury every year and as a result has only $53 billion of equity backing up almost $2.7 trillion of assets. If the Fed were a private bank it would be immediately classified as critically undercapitalized and seized by regulators.
The Fed was there for Citigroup and Goldman Sachs and the entire financial sector but who will be there for the Fed?
As a practical matter the Fed cannot hedge its interest rate risk. While other banks can buy interest rate swaps, futures and options, the Fed is not like other banks and will be subject to a double standard.
The Fed will never collect on hedge contracts bought from Wall Street oligarchs. Hedging is a zero sum game —if the Fed makes money that means someone on Wall Street loses.
The “too big to fail” banking crowd will make the Fed’s hedging contracts uncollectable in less time than it takes to clean up after a K-Street cocktail party. There is just no way that Wall Street will voluntarily pay the Fed a few hundred billion when Congress is around for a bail out.
I happen to be a supporter of the Fed’s monetary policy and think that Mr. Bernanke and the Fed staff have done an amazing job. I am not suggesting that the Fed balance sheet is out of control or that they have been irresponsible by accumulating $2.3 trillion of assets.
However, the Fed staff just is not anticipating the firestorm of criticism it will receive when it stops earning money for Congress.
Mr. Bernanke has not laid the groundwork with the public for losses and is giving Fed haters ample ammunition to attack the institution. Just imagine if the Congress had to include funding for the Fed in debt limit debate.
In a perfect and intellectually honest world, losses at the Fed would be a non-event. But we don’t live in a perfect world. The Fed is setting itself up for political opportunists to take cheap shots without consequence.
By not dealing with the certain math of interest rate risk, Bernanke risks becoming the guy who gives Congress an excuse to end Fed independence.