Federal Reserve Uses Accounting Gimmick to Hide Losses

[FrankRep]

http://www.thenewamerican.com/images/stories2011/12aJanuary/federalreserveseal-t.001.jpg


Federal Reserve Uses Accounting Gimmick to Hide Losses (http://www.thenewamerican.com/index.php/economy/economics-mainmenu-44/6015-fed-uses-accounting-gimmick-to-hide-losses)



Alex Newman | The New American (http://www.thenewamerican.com/)
24 January 2011



The Federal Reserve announced that it would use a new accounting trick to conceal potential losses on its massive investment portfolio, transferring its liabilities to the U.S. Treasury instead - essentially preventing a central bank bankruptcy on paper, at least, right as the debate on its solvency heats up. By Alex Newman


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[Zippyjuan]

They did pretty good last year.
http://www.reuters.com/article/idUSN1027452220110110

WASHINGTON, Jan 10 (Reuters) - The Federal Reserve reported on Monday its earnings jumped by more than 50 percent in 2010 to a record $80.9 billion on its massive holdings of securities, and it is turning the bulk of it over to the U.S. Treasury Department.

The $78.4 billion that the Fed is remitting to Treasury is also a record and is $31 billion more than a year earlier. In 2009 the Fed had net income of $53.4 billion.

The Fed's portfolio has ballooned to $2.16 trillion, roughly triple its size before the financial crisis, as it purchased securities including U.S. government debt and mortgage-linked bonds in a move to drive down borrowing costs and stimulate the economy.

"The increase was due primarily to increased interest income earned on securities holdings during 2010," the U.S. central bank said in releasing preliminary unaudited results. Audited results will be issued in the spring and may show some changes, Fed officials indicated.



The Fed said its 2010 income included $76.2 billion in income on securities bought through open market operations, including Treasury and mortgage-linked debt, $7.1 billion from limited liability companies created in response to the financial crisis, $2.1 billion in interest income from credit extended to American International Group Inc (AIG.N) and $1.3 billion of dividends on preferred interests in AIA Aurora LLC and ALICO Holdings LLC.

[hugolp]

^^ Zippy if you create money and start buying treasuries and mortgage shit you are going to get a lot more interest and will be able to pay more profits in the short term. Its not rocket science. If you give me the printing presses I can do it too. The problem is that reality is setting in and what the Fed bought is starting to show as a bad investment, therefore producing loses.

The fact that the Fed is chaging the acounting rules just now to hide loses is very telling. But you can hear it from Bernie himself:


"Under a scenario in which short-term interest rates rise very significantly, it's possible that there might come a period where we don't remit anything to the Treasury for a couple of years. That would be I think a worst-case scenario," Bernanke said.
http://www.reuters.com/article/idUSN108007520110111

[Zippyjuan]

That is certainly possible if they are forced to sell off their holdings to try to pull back on all the money they put out there. If they hold their securities until maturity then they won't lose money.

[hugolp]

That is certainly possible if they are forced to sell off their holdings to try to pull back on all the money they put out there. If they hold their securities until maturity then they won't lose money.

But then the Fed would have no capacity of removing or controlling the massive amount of money that it injected in the banks. Do you see the problem? The Fed is trapped and we are going to pay for it.

[gonegolfin]

That is certainly possible if they are forced to sell off their holdings to try to pull back on all the money they put out there. If they hold their securities until maturity then they won't lose money.
First, let us be clear that we are only speaking of bank reserves, not money supply. The Fed did not inject money into the money supply with its balance sheet expansion. It has been increasing bank reserves, small portions of which (illustrated by the conversion of excess reserves to required reserves) have been leaking into the money supply via bank investment and lending.

Second, if the Fed were forced to hold all of their purchased securities (from the various balance sheet expansion efforts) until maturity, this renders the Fed impotent with respect to managing bank reserves (monetary policy) over a very long period of time. This is not a solution as it would be rendering itself a defunct organization, unable to perform its core operation. Bond traders would destroy the currency and interest rates would skyrocket. Without being able to sell assets (shrinking its balance sheet), the Fed could only raise the interest rate paid on reserves. This is not a solution either as the Fed would be attempting to choke off monetary inflation with a flimsy tool (paying interest on reserves) while pumping more reserves into the system as the Fed is forced to push this interest rate higher. It should be obvious that paying interest on reserves is not a long term policy approach to managing reserves in the banking system, but a desperate stop gap measure. But if it is not, I can expand on this. The market has not called the Fed's bluff thus far because enough of the market believes that the Fed will execute some sort of traditional exit (meaning balance sheet contraction to normal levels). If it were announced (or became obvious) that the Fed were to hold all securities to maturity, big problems would ensue.

Third, the accounting rule changes themselves are not a big deal in my mind. The Fed is not a traditional organization where annual profits are accumulated as stockholder's equity. Instead, they are remitted to the Treasury each year. Thus, the Fed is forced to start at zero each year. So, from strictly an accounting perspective, a few years of even significant losses would not destroy the equity built over the years in a traditional accounting sense. Instead, I think the following is important ...

1) Exactly why and how does the Fed generate profits in the first place? (a rhetorical question of mine that the general public should be asking)

2) The Treasury must issue more debt to cover the shortfall of proceeds it traditionally receives from the Fed

3) I do not think this accounting change will conceal losses in the Fed portfolio ... rather I think it will illuminate them. It will be obvious to all that the Fed has incurred a loss and the amount will be evident on the Fed balance sheet as a liability to the Treasury (and offset by any future profits)

4) Losses incurred by the Fed prevent the Fed from draining the bank reserves it originally created with those purchases. This is a very big deal and forces the Fed to adopt very unconventional measures to implement monetary policy (that cannot succeed long term).

I wrote about #4 above in July of 2009 ... Fed Exit Strategy? (http://financialsense.com/contributors/brian-benton/fed-exit-strategy) An excerpt ...

"But I want to focus more on the last item above (#5) as it is not being discussed in terms of the quality of assets being held by the Fed. The assumption has been that the Fed will be able to drain all (or most) of the reserves it originally created. But since the Fed is going further out on the yield curve with treasuries, it is more susceptible to interest rate risk. If the Fed were to drain reserves by selling these longer term treasury assets (which would also put upward pressure on interest rates), the price that these assets would fetch would quite likely not be enough to drain the amount of reserves originally created when it purchased them. Also as I have previously discussed, the composition of the balance sheet is getting shakier. I think that this may ultimately be the larger problem, as opposed to the sheer size. This may become a serious problem as MBSs, longer term treasuries, and other assets held by the Fed decline in value relative to their inflated purchase price (especially as the Fed commences the selling of these assets and interest rates rise). In other words, simply the Fed saying that it will execute a proper exit strategy (draining the reserves it created) is not enough with the prices of their assets falling. Meanwhile, much more debt remains to be auctioned (both domestically and globally). There will be much competition for scarce funds globally, which will place upward pressure on interest rates. Thus, the Fed will likely find itself in a position where the assets it holds are falling in price while it needs to assist the Treasury market by purchasing treasury debt ... which will add reserves to the banking system making a successful execution of the Fed exit strategy even more difficult. I think that eventually, another option may surface, but will require congressional approval. I have discussed it in prior missives ... the issuance of Federal Reserve interest bearing debt (which would compete with Treasury debt)."

Brian