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Who’s Gonna Bail Out The Fed?

As pub­lished on Forbes.com

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.

Posted in: economy, Federal Reserve, Finance, Monetary Policy, Politics, Public Policy, UNITED STATES

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