The FED’s Shell Game? Profitable or Insolvent?

02.02.2011 original publish date
12.12.2012 replaced broken links with original PDF archive.


The FED’s Shell Game? Profitable or Insolvent?

original article written by Net Advisor
On January 10, 2011, the Federal Reserve (The FED) announced that they had an estimated record 2010 net income of $80.9 Billion [Source: The Federal Reserve (PDF)].

In fact, the FED made so much money, “it is turning the bulk of it over to the U.S. Treasury Department” [Source: CNBC (PDF)]. Now keep in mind the FED received most of its money from government bonds, including U.S. Treasuries and government agency bonds.

“…the Fed said the estimated 2010 net income was derived primarily from $76.2 billion in income on federal agency and government-sponsored enterprise, or GSE, mortgage-backed securities, U.S. Treasury securities, and GSE debt securities.”

— Source: Wall Street Journal (PDF)

Back in 2009, the FED earned a record $45 Billion (Source: Washington Post). However, the Atlantic reported the FED earned $53.4 Billion in 2009. So somewhere between Washington and the Atlantic, the FED apparently made a lot of money.

The FED invested about $2.16 Trillion (PDF) to buy mostly U.S. Treasury Bonds with the goal of keeping interest rates down close to zero (Jan 20, 2011 FED Balance Sheet (PDF), noted bottom line highlighted in yellow, P12). Technically speaking, the FED calls this their “Intended federal funds rate” where their goal right now is to keep the FED Funds Rate somewhere between 0% to 0.25% (that is zero to one-quarter-of-one-percent).

The FED is effectively trying to keep control the free market (bond market) interest rates through what is called their monetary policy. This effort generally worked during the economic-housing-credit-(insert problem here)-crisis from 2007 to most of 2010. I would probably support that most of the FED actions were necessary in 2008 to early 2009 to help avoid a total economic collapse of the U.S. banking, credit market and financial systems.

Since large scale government bailouts are not politically popular, the FED is arguably taking on the government’s role in trying to further reflate (stimulate) the economy. The FED must know that there are still economic issues that are unresolved such as high unemployment. As a result, the FED has lowered expectations on U.S. economic growth (Source: Washington Post).

On August 27, 2010, Chairman Ben Bernanke stated that the FED ‘was prepared to take dramatic steps to boost…(economic) recovery but only if conditions get worse’ (Source: Washington Post). About two months later on November 3, 2010, the FED announced that it would launch a new economic stimulus program called quantitative easing or “QE2” – the number two added because this is the second time the FED has made a major stimulus program to monetary policy.

Karen Dynan, at the Brookings Institution, a nonprofit public policy organization based in Washington, DC said that this new round of quantitative easing “while unprecedented, is warranted—although it won’t provide the magic bullet to cure all of the nation’s economic ills.” Dynan also noted that the economy is still “very weak” and believes the (new FED action) benefits outweigh the risks (to the U.S. economy) (Source: Brookings Institution).

The FED has since took on what arguably a lot of risk to print money and buy U.S. Treasuries. Unfortunately, by using their power to which has not worked as of late (Source: International Business Times, PDF) .

In fact, the FED is pumping $600 Billion in the economy via purchasing U.S. Treasuries to help keep long term interest rate down (Source: Bloomberg). Since the start of this effort, the reverse happened: Long term interest rates went up a full percent to a five month high and in under two months from October to December 9, 2010 (Source: CS Monitor). These rates can impact the cost of adjustable rate mortgages and present an increased cost to new home buyers seeking to finance their home purchase.

The FED: Cash Machine or Running Near Empty?
Just 11 days after the FED paraded the media with their fanfare of record earnings and how they are handing the bulk of their “profits” over to the U.S. Treasury. The FED’s next move is an accounting trick to help the FED so it won’t go broke. WHAT???!!! The FED going broke? How can they go broke if they earned all those mega billions, and so much money that they could just hand it over to the U.S. Government (Treasury)?

The FED is implementing an accounting trick so that if they take losses on the $2 trillion+ securities they are holding, that it somehow won’t make them appear to have a decrease in capital.

“An accounting methodology change at the central bank will allow the Fed to incur losses, even substantial losses, without eroding its capital.”

— Raymond Stone, Managing Director at Stone & McCarthy (Source: Reuters)

Further,

“Any future losses the Fed may incur will now show up as a negative liability as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible…”

— Brian Smedley, a rates strategist at Bank of America-Merrill Lynch and a former New York Fed staffer (Source: Reuters)

Wouldn’t it be great if we could all just change the way we account for our finances and tell the banks there is no way we can lose money or go bankrupt? Why is the FED doing this? We’ll, as most of know that when you make an investment there is a risk. And that risk includes a risk of losing money.

The problem is that FED printed so much money ($2.3 Trillion+) to create the second largest bailout of the U.S. economy that in the event of inflation, the FED could start taking huge principle loses on their government bonds. Note: The U.S. Federal Government total bailout of the U.S. economy as of 11-16-2009, was about $3 Trillion, with $11 Trillion total committed toward bailouts (Source: CNN). Keep in mind that the U.S. doesn’t have $11 Trillion, let alone $3 Trillion. This also does not include the $3 Trillion Obama “stimulus” spent in the last 2 years (Source: CBS News).

So What’s the Risk?
According to Varadarajan Chari, economics professor at the University of Minnesota and a consultant to the Minneapolis Fed stated that the FED could actually be technically broke “on paper.”

“The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by a couple of percentage points, it would dent the value of those holdings by about 10 percent, leaving the Fed with a $100 billion loss.”

— Source: Reuters

Hey what’s a $100+ Billion in losses if you can just print more of that green stuff?

So the FED may not go broke now because it is changing how it does its accounting. The challenge here is that it is hard to say that the FED is “profitable” in the near $90 Billion range, and yet on paper is also technically broke, or near broke. So which is it really? Is the FED truly fine, or are there real risks that it takes some accounting gimmicks to show one’s solvency?

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Related Articles:
Uncle Ben, Inflation is Already Here
Who Do You Believe? Today’s Mixed Headlines
Economic Crack. Risk to The U.S. Economy

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