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To the Fed - Defer this!

Bruce Krasting's picture





 

 

The Federal Reserve makes a ton of money on its $3T horde of government bonds. In 2012 the Fed earned a tidy $90B by borrowing short and lending long. That income number is the difference between interest income and expense. The P/L does not reflect the fact that the Fed has a huge unrealized gain on the portfolio (The Fed takes capital gains and losses only when securities are sold). According to a recent Fed report, the Fed is sitting on unrealized gains that are in the neighborhood of $200B.

 

This chart shows how big the Fed's contributions to Treasury have been over the past few years. The Fed's net income has cut 10% off of the annual deficit.

 

fedincome

 

The question that hangs in the air is what happens if interest rates were allowed to "normalize". Fortunately, there is an answer to this question. The source of this information is interesting, it comes from the Federal Reserve.

 

Screen Shot 2013-01-26 at 11.54.28 AM

 

This is a technical report and covers many "what ifs". One critical assumption is what does the Fed do in 2013. That question has been answered, the Fed has done QE#4 and will grow its balance sheet at the rate of $85B per month. This result is reflected in the red-dotted lines in the following charts.

First a look at the interest rate assumptions that drive the results at the Fed:

 

fedfunds

 

10year

 

On the assumption that those rates will be the reality, then this is what would happen to the Fed's income statement:

 

fedpnl

 

Note that in all cases, the years of $80b Fed gains are over. Note also that if interest rates do rise, the annual return to Treasury quickly falls to zero, and actually goes negative (loss).

The Fed's balance sheet would get crushed (on a mark-to-market basis). The $200B of unrealized gains would fall to an unrealized loss of $300B. A half-trillion dollar swing in just a few years.

 

unrealizedgains

 

Let's say it plays out like this. What does in mean if the Fed has annual losses and and a big hole in its assets? The answer is, "Not much".

 

- The annual remittances to Treasury would fall to zero, That would, by itself, add to the deficit. The magnitude of the change (-$80b) would not be that big of a deal.

 

-If the Fed takes an annual loss, an accounting "asset" is immediately created equal to the loss. The asset would be in the form of a future claim on remittances to Treasury. This is an accounting gimmick.

 

If the Fed had a $50B loss in year #1, a $50 Deferred Asset is created. If in year #2 the Fed has a$50B profit, the money is first used to reduce the Deferred Asset. If you believe that the Fed will earn a profit over time to offset current losses, then the Fed can never be consider insolvent.

 

This is the Fed's explanation of the magical accounting:

 

The deferred asset is subsequently realized as a reduction of future remittances to the Treasury. Thus, it is an asset in the sense that it embodies a future economic benefit that will be realized as a reduction of future cash outflows.

 

The Fed goes on to defend this (flaky) logic with:

 

This accounting treatment is consistent with U.S. GAAP and is similar to the way that private companies report deferred loss carry forwards as an asset.

 

Well, that is "sort of" correct. This situation can arise with a private sector company. Tax loss carry forwards are an asset. But they are an asset that analysts look askance at - for obvious reasons.

The Fed is not just a Central Bank. It is a regulator for the nation's biggest banks. If one of those banks tried to use a $100B tax loss carry forward as an asset, the Fed would put the screws to them. For example:

 

-The Basel II capital requirements specifically exclude Deferred Taxes as a qualified asset. (So how can the Fed treat it as equity?)

 

-The Fed has restricted Citi from stock buy-backs and dividends because the bank has $50B in Deferred Tax assets on its books. (Good for the goose, but not the gander...)

 

Note: This is an odd report to be coming from the Fed. What to make of it?

I put it on the growing list of "things" that are suggesting that the Fed is pondering a change in direction. If there are any 'tea leaves' in the analysis, they would read that QE is going to be ending pretty soon.

The Fed is aware of the risks it is taking. The report quantifies the risks in an orderly, but scary way. The fact that this report exists, confirms to me that some Fed members are increasingly uncomfortable with those risks.

 

defer

 

 

defer_k2s_crew_in_downtown_los_angeles

 

 

 

 

 


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Mon, 01/28/2013 - 05:26 | Link to Comment hooligan2009
hooligan2009's picture

smoke and mirrors = one government department (treasury) borrowing from another..pretty much the same as the social security trust funds.

the christmas parties at these departments are generally fancy dress, but not toga parties...emperors clothes parties.

it makes no difference if the Fed cancels debt owed by the Treasury, in the same way it makes no difference if the Treasury cancels "losses" made by the Fed.

in fact, i go further..it would be stupid of the fed to ever sell its treasuries, or the treasury to stop receiving profits or paying losses to the fed. it makes no difference.

of course the MBS holdings are different, but then fraudie and funny (shit) i mean freddie and fanny have been nationalized errrrrr... in conservatorship. hence one other government department owes another government department money..more smoke and mirrors and posing in emperors clothes. the underlying assets at fraudie and funny though are actually real... they are voters houses.

but then.. all these games..who owns the government? we do..so all the smoke and mirrors are devices to fool ourselves that we are living within our means and polticians are doing what we tell them to do...bleh...

Mon, 01/28/2013 - 00:37 | Link to Comment Notarocketscientist
Notarocketscientist's picture

And here we have yet another corrupt cocksucker from Goldman

 

Goldman's role in the Russian crisis was criticized at the time because while the company was advising Russia it was simultaneously betting against the country's ability to repay its debt.[7]

 

http://en.wikipedia.org/wiki/Mark_Carney

Mon, 01/28/2013 - 00:37 | Link to Comment Notarocketscientist
Notarocketscientist's picture

And here we have yet another corrupt cocksucker from Goldman

 

Goldman's role in the Russian crisis was criticized at the time because while the company was advising Russia it was simultaneously betting against the country's ability to repay its debt.[7]

 

http://en.wikipedia.org/wiki/Mark_Carney

Mon, 01/28/2013 - 00:07 | Link to Comment IamtheREALmario
IamtheREALmario's picture

The Fed "borrows"? I thought all they did was create money out of thin air and give it to their crony cabalist friends.

Sun, 01/27/2013 - 22:50 | Link to Comment newengland
newengland's picture

The Fed needs to be fed. It's going to be fun to watch them fall out among themselves, bunch of greedies.

Sun, 01/27/2013 - 22:12 | Link to Comment jomama
jomama's picture

the show must go on.

Sun, 01/27/2013 - 21:25 | Link to Comment news printer
news printer's picture
Peter Schiff + Coming debt crisis will make 2008 look like a Sunday school picnic

http://goo.gl/aoprM

Mon, 01/28/2013 - 01:21 | Link to Comment JuicedGamma
JuicedGamma's picture

Link is shit. Don't bother.

Sun, 01/27/2013 - 18:55 | Link to Comment MrPalladium
MrPalladium's picture

You guys are all missing the point. The Fed is abundantly aware that an incessant piling up of treasury paper on their balance sheet looks more and more like an implied threat that they will ultimately sell.

That threat could, without any action by the fed, at some point panic the markets.

What the Fed really wants to do is to cancel the debt it has purchased, which is the functional equivalent of stating that they will hold it forever. Cancellation reduces interest cost even more than rebating interest on those holdings - minus the vig - to the treasury.

The roadblock in the way of cancellation is their self imposed accounting rules which would require them to "take a loss" on the cancellation and then hold some sort of asset account or contra-liability account.

If they are going to cancel they do not want any accounting fiction detracting from the permancence and irrevocability of the cancellation, or to disrupt FED operations, distract Congress, or otherwise serve as a memorial to the wild easing orgy that cancellation would imply going forward.

In other words, the report is about optics, not substance.

Sun, 01/27/2013 - 19:26 | Link to Comment kaiserhoff
kaiserhoff's picture

Incoherent and yet contradictory. Are you related to ilene?

And still you managed to stumble into the one salient point in the Fed's recent hype and arm-waving.

1. The problem has never been "self imposed accounting rules."  Government accounting is a set of lies agreed upon, and nowhere worse than the Fed.

2,  The Fed has nothing of net value to "sell'.  It has massive losing positions to unwind, and yes that process would not just panic, but destroy many markets.

3.  Exactly right on cancellation, the real agenda.  Cancellation opens the back door to financing all government crimes through printing, and as you say, makes the dollar worthless.  Because, like all of Ben's treason, once it begins, there is NO EXIT STRATEGY.

I'll make it simple, boys and girls.  The Gubbermint runs a deficit, let's say 10 trillion.  It borrows the money from the Fed, and then the Fed cancels the debt.  Wash, rinse, repeat.  Just like printing 10 trillion in $100 bills, and coming to a country near you soon.  The question is, what can we do about it?

Sun, 01/27/2013 - 23:30 | Link to Comment Widowmaker
Widowmaker's picture

I feel like im watching two retards argue the same point on the short bus.

What "markets?"

Sun, 01/27/2013 - 18:25 | Link to Comment WarPony
WarPony's picture

Not ALL profit goes "straight" to the Treasury, not with their cost-plus k with a built-in, GUARANTEED 6% PROFIT with the U.S.A. to have the monopoly to print FRNs unaudited and legally un-auditable, OMW and ALL.

Sun, 01/27/2013 - 18:20 | Link to Comment kaiserhoff
kaiserhoff's picture

This chart shows how big the Fed's contributions to Treasury have been over the past few years. The Fed's net income has cut 10% off of the annual deficit.

 

OK, Bruce.  I see where you get the 90 Billion (contribution), but what if the fed where not engaged in Soviet Central Planning?

Hundreds of billions (trillions?) of dollars would be earned by savers and TAXES WOULD BE PAID on those profits.

The damage done to the economy is a multiple of any contribution to "deficit reduction."

This is much worse than the usual policy wonk crap.  I would flunk any junior in managerial accounting who came up with such a shallow, one-sided approach. 

Sun, 01/27/2013 - 17:48 | Link to Comment steveo77
steveo77's picture
I made this chart, yes the Nuke Pro made it. Several other blogs have copied it nearly verbatim, and I am happy that others want to spread actionable information to protect people (would have been nice to get a proper credit though). I had the chart translated to Japanese as i was sending a Geiger to Japan to help families address their real risk. See bottom for the Japanese version.

This is a super condensed table on how to interpret Geiger Readings. Use it to supplement your own research and getting a "block of knowledge".

If you take this radiation stuff at all seriously, then get a Geiger. All the rest is guesswork.
http://nukeprofessional.blogspot.com/2012/04/geiger-counter-interpretation.html

Sun, 01/27/2013 - 14:55 | Link to Comment 100pcDredge
100pcDredge's picture

How long can the Fed postpone?

Ehm... forever?

Am I right?

It's magic, isn't it?

Sun, 01/27/2013 - 17:35 | Link to Comment All Risk No Reward
All Risk No Reward's picture

The Fed postpones until the ologarchs that run it (Bernanke is a tool) determine the cost/benefit ratio of ripping off Muppet faces in bailout looting goes against them.

Then the collapse will be engineered to consolidate the nation's assets under the oligarch corporate fronts.

Then the serious inflation comes in so that the oligarchs can balance their books now that they've traded their cash for ownership of the Earth.

Got that?

It's so elementary, but bankster financed propagandized dogma and ideology blinds so, so, so many people.

Mon, 01/28/2013 - 00:37 | Link to Comment Almost Solvent
Almost Solvent's picture

I hope the fossil fuel complex collapses before the real war starts, although WW3 will consume what little fossil fuels we have left.

Sun, 01/27/2013 - 13:39 | Link to Comment ouchtouch
ouchtouch's picture

Can the Fed ever raise interest rates?  Wouldn't it cause a massive bond crash and currency crisis?  Don't they realize this?

Sun, 01/27/2013 - 13:28 | Link to Comment Madcow
Madcow's picture

Financial Antigravity Device <FAD>

 

or Financial Anti Gravity Device  <FAG-D>

Sun, 01/27/2013 - 07:14 | Link to Comment “Rebellion to t...
“Rebellion to tyranny is obedience to God.”-ThomasJefferson's picture

 

 

FUBAR

Sun, 01/27/2013 - 03:32 | Link to Comment dunce
dunce's picture

I do not understand any of this but i believe that there will be an economic disaster at the end of all this money shuffling between the fed, the treasury, and the banks, and the general taxpayer is going to be gang banged in the end (chronologically and metaphorically) by all these people who fancy themselves as masters of finance. With enough PM you might not know real poverty but most people will.

Sun, 01/27/2013 - 02:05 | Link to Comment Cosimo de Medici
Cosimo de Medici's picture

Wait a second!  I went and read the Fed document.

While the Fed document doesn't diminish the crux of Bruce's argument, the notion of a "deferred asset" requires a bit more explanation, as it is peculiar to the nature of the beast.

The Fed is an odd kind of non-profit entity, so its accounting is necessarily weird.  Its capital base comes from its member banks as well as "retained earnings".  Member banks must pay in capital at a rate that is tied to their own capital.  As member banks' capital rises, they must put more capital into the Fed.  By mandate, the Fed must equally match the paid-in capital of its members.  The Fed matches by putting some of its profits into the capital account (or by debiting its account of monies owed the USTreasury).

Given the above mandate, when the Fed makes a "profit" it either goes to make sure its own portion of paid-in capital exactly equals the capital contribution from its member banks, or else it must turn the profits over to Treasury (minus the % dividend paid to member banks based on their capital contribution).  It does not play the game like AAPL and just keep increasing its "retained earnings".  Thus, absent this capital requirement and dividend, the "profits" of the Fed serve on the balance sheet as a liability (to Treasury) in almost an off-setting manner to how losses are booked as "deferred assets".

Granted the whole machination of money creation and its resulting "profitability" are nonsense, but what at first glance might seem to be bizarre accounting is, in an odd way, somewhat consistent.

Where the accounting might come back to bite the Fed in the butt is if the Fed occurs, as Bruce writes, a series of yearly operating losses.  What if the Fed "loses" but bank capital increases?  The member banks will still be required to add more capital to the Fed, but the Fed will not be able to match the increases by debiting its "owed to Treasury" liability.  Even if the Fed doesn't realize losses or mark to market, in a year of rising rates (and thus a fall in the market value of rate-based bonds), Fed operating costs will exceed its profits.  In other words, the Fed will still incur salary obligations, light bills, etc., but will have no earnings to fund these costs, much less match member banks' paid-in capital increases.

In what appears to be the Fed demonstrating yet again its own lack of predictive powers, there is a curious line from Pages 13-14 of the Fed PDF document, which I add without editorial comment:

One consequence of the current implementation of Federal Reserve Bank accounting policy is that the recording of a deferred asset implies that Reserve Bank capital does not decline in the event of an operating loss. From time to time, individual Reserve Banks have reported a deferred asset; however, these deferred assets were generally short lived.  It has never been the case that the Federal Reserve System as a whole has suspended remittances to the Treasury for a meaningful period of time because of operating losses.

Okay, a little editorial comment....what if rates rise for many years in a row?  Isn't this possible, even likely, arising as it will from years of ZIRP?

How does a Central Bank survive its own mandate?  It gets hoisted by its own pitard, it seems.

Sun, 01/27/2013 - 10:02 | Link to Comment sansnobel
sansnobel's picture

I think you guys are missing the point with your balance sheet and accounting arguments.  They are a FRAUD!!!!!!!  They don't have capital!!!!! They can materialize "Capital" out of thin air and buy the debt of the United States Government.  Any attempt to disguise this fact with a bunch of GAAP accounting mumbo jumbo is just engaging in mental masturbation.  They don't have a "Balance sheet".  You have got to be shitting me.......This game will go on in perpetuity as long as they can cleverly conceal this fact from the public at large.  What is QE if it is not materializing digital dollars (aka Counterfeiting) into existence,  that which did not already exist before on someone elses "balance sheet"?

Sun, 01/27/2013 - 11:13 | Link to Comment Cosimo de Medici
Cosimo de Medici's picture

See my comment to Bruce.  The Fed is running up against its own system, which itself is illusory and requires suspension of logic.  We all know that.  Bernanke knows that.  In order to keep their system afloat, they will have to amend their original mandate.  That action will have consequences.  It will create problems here and problems there.  It would be prudent to anticipate how they will try to "keep hope alive", so as to stay out of the way of whatever blowback that action might initiate.

Sun, 01/27/2013 - 14:42 | Link to Comment machineh
machineh's picture

How many PhDs does it take to fudge away a negative new worth, without waking up 535 innumerate morons in Congress?

Sun, 01/27/2013 - 09:29 | Link to Comment Bruce Krasting
Bruce Krasting's picture

The value of a Deferred Asset is a function of how quickly it can be used. To use the Asset, it is necessary to have a profit.

Consider GE. It lost a ton in 2010. It created a Deferred Asset. Today GE is profitable, and is using those tax loss carry forwards to shield current profits.

So in this case, the Deferred Asset was legitimate. The timing gives credibility/value to the "Asset".

 

Now consider Fannie and Freddie. They have huge losses, so they (in theory) have Deferred Assets. But Fannie and Freddie will never be profitable again, so those Assets are worthless.

 

Fannie and Freddie wrote off their deferred assets.

 

You ask what happens if the Fed is forced into a multi-year loss. Say it is the six years that was in the report. Say the total of losses is $300B. (Deferred Assets = 300b). Say that after 6 years the Fed goes back to making $30B a year

Result: I just described a 16 year cycle from first loss to full recovery. A Deferred Asset that has a 10+ year recovery prospect has an economic value of ZERO. It would, in my opinion, be treated as it was with Fannie and Freddie - a permanent impairment.

Sun, 01/27/2013 - 23:52 | Link to Comment Bear
Bear's picture

I have a ton of deferred 'assets' ... they are called capital loss carryovers on my Federal taxes

Sun, 01/27/2013 - 11:09 | Link to Comment Cosimo de Medici
Cosimo de Medici's picture

I believe we said roughly the same thing.  Neither the Fed mandate nor the Fed PDF cited in your article considers the possibility you outlined.  They built the system, however Potemkin-like it is, yet they still cannot function within it.  They will be short mandated capital.  They will be required to lay a layer of farce over the existing farce.

Sun, 01/27/2013 - 10:53 | Link to Comment machineh
machineh's picture

In all seriousness, the Fed has one massively undervalued asset on its balance sheet -- $11 billion of gold valued at only $42.22 an ounce.

Obviously they aren't going to breathe a word about this idea for now.

But if the Fed gets backed to the wall, they will revalue their gold to market, picking up a quick $450 billion or so in 'found money.'

Scandalous as a Saturday night special ... but don't shoot me, I'm just the messenger.

Think like a criminal.

Sun, 01/27/2013 - 20:41 | Link to Comment rufusbird
rufusbird's picture

Well, there are always, 'Death Spiral' Convertable Preferred Stock, which used during the late 1990 Tech stock market bubble. Whew! Talk about getting your tail twisted. Ouch! (don't laugh. You have a variation of them in your wallet!)

Sun, 01/27/2013 - 01:19 | Link to Comment q99x2
q99x2's picture

I say jack the price of the housing market and offload that shit to the Chinese and Hedge Funds.

Sat, 01/26/2013 - 23:28 | Link to Comment Cosimo de Medici
Cosimo de Medici's picture

Quite the game when a player can determine the metrics by which "profitability" is measured (rates effect) and also conjure the means to acquire profit-making assets (printing).

What might prove most confusing is to consider the losers in a rising rate scenario, and how much they lose.  The losers are those without fixed rates on their debt, plus those with the ongoing need to borrow (like the USG).  Corporates, on the other hand, have issued a ton of paper at low rates, and would even incur a huge "gain" if rising rates make the market value of their debt less than its current book.

Elsewhere, housing would be affected if it was actually recovering, which it is not in the traditional manner.  Sales are only a quarter what they were in 2006, and many of today's sales are all cash and purchased as rental assets.  Demographics and student debt levels suggest housing will be dead for years, no matter the rate.

So who loses?  The USG, obviously.  Banks, too.  Why banks?  All those assets put on since the implementation of ZIRP have to be funded and refunded on an ongoing basis.  The book is never matched, but rather long term assets are funded by much shorter term money.  In a world where savers have been starved for yield for five years, just watch what happens to M1 when rates rise.  Say good-bye to demand deposits.  To think banks can hedge their funding risk is like saying portfolio insurance made sense in 1987.  If short term rates get back to 2003 levels, all banks will have a negative interest margin. 

Then they'll need another bailout, which means the Fed buying the banks' assets and re-implementing ZIRP...and we're all back here again.  How many times can we be fooled?

Sat, 01/26/2013 - 22:11 | Link to Comment otto skorzeny
otto skorzeny's picture

I can't believe Bruce even addresses this whole Ponzi scheme as anything less than a total farce (disclaimer-long ammo)

Sun, 01/27/2013 - 15:14 | Link to Comment Hobie
Hobie's picture

He didn't say it wasn't. If you read the article carefully enough you might realise what was implied.

Sat, 01/26/2013 - 23:24 | Link to Comment Hedgetard55
Hedgetard55's picture

+55 kajillion Otto.

Bruce is a fucking idiot, to be plain and simple.

Gains or losses to the FED are meaningless, the currency debasement is what pays for them. Bruce is too fucking stupid to understand that.

Sun, 01/27/2013 - 17:51 | Link to Comment All Risk No Reward
All Risk No Reward's picture

The "money printing" psy op has worked on you.

The debt is, most assuredly, not meaningless.

It is the control mechanism by which oligarch convey the wealth of society to themselves.

The bankster financed and controlled government is not going to zero out the trillions in bankster debt holding and cash assets.

The banksters aren't lending 15 years at 2.5% ahead of a currency debasement THEY WOULD HAVE TO CHOOSE TO ENGAGE IN.

Don't repeat what others have told you - think it throw logically for yourself.

If you owned trillions in cash, trillions in debt and you controlled the issuance of currency and credit, WOULD YOU DEBASE YOUR WEALTH AWAY TO BAIL THE DEBTORS YOU ARE CURRENTLY LOOTING RAW?

Would you compound the problem by lending 15 years at 2.5%?  Or 30 years at 3%?

I wouldn't. You wouldn't.

BUT THAT''S YOUR ARGUMENT.

Don't confuse the false narrative with the underlying reality.

A man always has two reasons for doing anything: a good reason and the real reason.
J. P. Morgan

You are propagandized with the "good reason."

You must figure out the "real reason" on your own.

Don't just believe the establishment financed main stream and establishment funded controlled opposition "good reasons."

You think, therefore you are.

PS - I may well be wrong here...  but you should have the logic to explain why my thought process is not logical.

Maybe it is possible for the thieving banksters to bail out debtors while they torch their trillions.  If so, let's hear it.  I'm open to discussion.  In fact, I'd love for someone to prove my thesis wrong as it is filled with all kinds of horror for the common people like me and mine.

 

Mon, 01/28/2013 - 01:13 | Link to Comment socalbeach
socalbeach's picture

The currency debasement, not extreme hyperinflation, is being (partly) accomplished by the Federal Reserve overpaying for banks' mortgages, and giving banks access to nearly zero interest rate credit that they can use to buy higher yielding assets. Both of those measures help the banks overall, even though they would cause a loss in the purchasing power of the dollar. Put another way, if the Fed were to hand you and I a trillion dollars each for say our refrigerator, most everyone else would lose.  But if they hand out a few trillion to the banks, the banks win even though the value of the dollar would erode due to the extra reserves in the system. Most people with debt who can refinance at lower rates also win, but that's incidental and not the primary purpose of the Fed's actions.

Thirdly, the banks in aggregrate only lend out a fraction (I don't know the number) of their capital, mostly they're just loaning out customer deposits.

So that would be 3 reasons why your reasoning regarding currency debasement could be wrong.

Mon, 01/28/2013 - 00:32 | Link to Comment Almost Solvent
Almost Solvent's picture

You're 100% correct that war is coming.  

 

War is the outcome, always has been in the whole recorded history of mankind.

 

And war shall be the outcome again.

Sun, 01/27/2013 - 15:15 | Link to Comment Hobie
Hobie's picture

And name calling makes you intelligent?

Sat, 01/26/2013 - 21:42 | Link to Comment Whiner
Whiner's picture

Wha' happens to those Notes held by China, Japan and Co. when Fed arrives at buying up 100% of USTs? I know: they stop buying. But don't they also then start selling'em hand over fist? How then does Uncle continue to finance his welfare-warfare budget? Dollars come home. Much currency sloshing too and fro. Hyper-inflation.

Sat, 01/26/2013 - 20:51 | Link to Comment Downtoolong
Downtoolong's picture

No wonder I can't find any blue smoke and mirrors for my magic show. The Fed has cornered the market and bought them all.

Sat, 01/26/2013 - 20:37 | Link to Comment andrewp111
andrewp111's picture

The Fed will never take losses unless it pays higher IOR. The Fed will never unload the Treasury bonds on its books, so it will never realize those losses. It will hold them to maturity, collecting interest every year. The only possible exception is mortgage backed securities. In theory, they could default.

Sun, 01/27/2013 - 00:34 | Link to Comment tom
tom's picture

Exactly. Since the Fed has stocked up with so much low-interest, long-term assets, if rates went back to normal, its IOR payouts would be greater than its interest income, until after some years enough of its old, low-interest, shorter-term assets were rolled over into new, normal-interest assets. The Fed makes money off the spread between the average rate on its assets and IOR, and would lose money if that spread were negative.

Any gains or losses the Fed makes are automatically passed on to Treasury. It would be interesting to see a serious analysis of how much a return to 4% interest would cost Treasury. This paper isn't it. It would be hundreds of billions extra every year, and mounting every year as Treasury rolled over more and more of its low-interest debts into higher interest paper. Twist badly exacerbated the problem by putting all the long-term debt at the Fed.

Actually, the Fed's MBS can't default because they're guaranteed by GSEs which are being bailed out by Treasury. But the losses end up in the same place anyway.

Sat, 01/26/2013 - 20:05 | Link to Comment jldpc
jldpc's picture

Oh come on; it is so simple; simple debtor/creditor law. Whenever now or later the creditor (FED) gives the debt back to Treasury, the debt is zeroed out. It's all one gubnit. So where is the harm; the big problem? So really guys, the FED is us/is not us; we the people? What do we care if the FED balance sheet entries for UST's bills, notes, bonds rises or falls or disappears? Who gains lor oses? Why do they have a balance sheet anyway? Just to make the accountants happy? who cares; profit or loss; they are not a taxable entity are they? Of course not. What do they lose? What do we lose? Nuttin! It is all a numbers on paper gimmick to give some people something to talk about. Now just because the FED gave credit to the primary dealers (and thus by pass through of more credit extensions their scum sucking friends the big banks), and why not they have gazillions on deposit with the FED who "bought" the Tres. paper - real party in interest; so the Treasury would have cash money to pay its bills - "our" bills (you know the social security and medical security program and the medicade security program and the disabilty program, and the feed the people program, and don't forget the politicians and their relatives, friends and cronies) with a military to protect it from the ever growing and widely spreading muslim threat, e.g., about 400 million folks under 30 without work or food por prospects; er oops, not real money like new paper money from the printing and engraving guys, the green stuff in your wallet; but credit on paper money. Besides credit is so much better than the green stuff, easier to use and hide in large quantities. Just read lately about the oldest Italian bank, ha , ha , ha. So come on, why be so serious? It's all just credit anyway. It comes, it goes, it passes around and when the full circle is complete, the borrower owes nuttin cause the creditor and the borrower are one and the same - US, i.e., we the people.

Sat, 01/26/2013 - 23:00 | Link to Comment mess nonster
mess nonster's picture

Something tells me the creditor and the debtor are never the same entity. I understand your idealism- you can always sign your name capital letter/lowercase letters, first name first, last name last; and join a constutionally sanctioned militia. But that won't stop the SWAT teams or the black helicopters.

Something tells me the FED is not owned by the people, or even by the gov't. Something tells me the FED is owned by someone else entirely, and that someone else is going to figure out how to get the vigorish, even if it means breaking the legs of every American in America. That's the tyranny of accounting. Pay up, or else!

Sat, 01/26/2013 - 20:00 | Link to Comment tom
tom's picture

Thanks for highlighting this paper. This paper helps explain why the last FOMC meeting minutes show several members preferring to cut QE short this year and several preferring to cut it off by early next year, apparently regardless of whether unemployment gets below the announced target or inflation overshoots. Some of them were currently non-voting hawkish regional Fed presidents, but some of them were apparently leftish Obama appointees worried about the impacts to the budget of all this QE.

This paper actually does a mediocre job of describing the problem. It pretends that the Fed will be able to drain down reserves by selling off its Treasurys and agencies. It doesn't get into the thorny problem that Fed asset sales drain both reserves and bank deposits, ie broad money. That makes asset sales a very strong destimulus that carry a high risk of tipping the economy into credit crunch and debt deflation. Look at the Japanese central bank, which invented QE more than a decade ago. How much of those assets has it sold off?

So in reality, the Fed is far more likely to raise interest rates by simply raising the rate of interest it pays on reserves. That costs a lot more than the capital losses the Fed would take from asset sales. The scale of the costs would be in proportion to the size of the Fed's balance sheet. 4% IOR on $4 trillion of reserves would cost $160 billion a year, and thanks to Twist the Fed is loaded up on long-term, low-interest Treasurys. So Obama appointees are looking at these prospects and thinking, how are we going to keep funding our programs.

Keep in mind that at the same time Treasury would be paying higher rates to borrow. Its interest expense would skyrocket if short rates returned to 4%.

The takeaway here is that the Fed's vaunted "exit scenario" is either myopia or a cynical bluff. Short rates won't go higher than 2% before the next recession, probably no higher than 1%. The multi-trillion Fed balance sheet is here to stay.

Sun, 01/27/2013 - 10:43 | Link to Comment machineh
machineh's picture

'The multi-trillion Fed balance sheet is here to stay.'

A truth so incontrovertible that it ought be chiseled into the granite lintel above the entrance of the Eccles Building.

The FOMC are cornered rats. Their date with destiny is bearing down on these cowering little rodents at an alarming velocity.

Got strychnine?

Sat, 01/26/2013 - 19:54 | Link to Comment humblepie
humblepie's picture

The Fed actually still has control over it's IR policy???? 

Sat, 01/26/2013 - 19:44 | Link to Comment El Gordo
El Gordo's picture

Since the Fed also sets interest rates (or at least acceptable "ranges") then it could be throw into a conflict of interest (no pun intended) if it were to become concerned with its bottom line.  However, since it's a quazi-government entity, realistically there is no bottom line, ergo, no conflict.  See how easy it is to think like a bureaucrat.

Sat, 01/26/2013 - 19:24 | Link to Comment Nels
Nels's picture

If the pain-in-the-spreadsheet foreseen by the Fed is caused by mark-to-market accounting, how do I place a bet that the Fed stops using mark-to-market numbers?

They still might be uncomfortable about the reality of the situation, but I'd expect that what they showed publicly would assume that any and all government debt was good and should be shown at face value on their books.

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