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To the Fed - Defer this!
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.
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.
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:
On the assumption that those rates will be the reality, then this is what would happen to the Fed's income statement:
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.
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.
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Geeze, if the Fed board members didn't get it at the end of 2007 as the recent release of its meeting minutes show--i mean they sounded like they had been shipped in from some time capsule cause everybody knew in general what was playing out at that point--how are they going to get today's mess that they themselves have created to fix the last mess that they never saw coming? You'd need an Al Capone type character aka The Untouchables ready to swing a pretty hefty Louisville Slugger in their board meeting to get these people--charitable noun--to do some useful thinking. But the hole is so deep it's far easier to stick their collective heads up their ass and hope nobody notices--although i'm certainly glad one of them commissioned a report!--probably just for cya. Wait 'til this spring when tax increases start to bite, and over the coming year as health care rates and gov taxes really set in, just at the wrong time--if the US economy starts going into the tank following the EU as it appears is happening and an already despondent US public starts to sense that they and we are fucked for the next four years (and the public obviously has economic concerns judging from recent polls, although the economy--except hopium--wasn't a priority in the election somehow) well everyone can bend over and scream in pain. We're locked in for four more--I'm not talkin' about party--i'm talking about an inkling of fucking economic competence. What we'll get is UGLY all over.
Bruce the fed has either been dead wrong in all it's forecasts and predictions or has lied and changed the measurements along the way. how do you factor that in here?
The interest rates used in the analysis are not a forecast of what will happen. The report answers the question, "What happens if interest rates rise by X?"
The rates used are are not exteme outcomes. If things were "normalized", we would have something that looks like what was used.
Will Fed policy ever be normal? Never. The Fed will always overshoot. That suggests that inflation would have to rise above 3% BEFORE the Fed backs off the gas. That outcome could lead you to an interest rate scenario that was higher than the one used for the calculations.
All in, I think the report did a good job of identifying the potential risks.
So the Fed could survive a "normalization" of interest rates - that's nice.
Could the Treasury?
What happens to interest on the debt as a percent of revenues under some of these projections?
The "normal" the Fed used produced Fed Funds at 4% and long rates at 5%. Not a crazy scenario - based on history.
What would this do to the debt cost at Treasury? It would explode. It would sink the ship.
This was a report on what could happen at the Fed if rates go back to normal levels over a period of years. The results from "normal" would be very hard on the FED, but that would be a sideshow. The defict would be shooting up, and the economy would be going into recession.
So I don't see how things could get back to "normal". But I also don't see perpetual QE in the future. The Fed has acknowledged that they already face a very big risk. They can't double down anylonger. To do so creates a systemic risk. To me, that's the important conclusion from the paper.
We are intering the box (we may already be in it). Once you are in the box, you can't get out. If you try to escape the box, you die, so you stay in the box and hope for the best.
Bruce I really appreciate the perspective. The fact that you can't see the fed doing qe forever makes me constantly re think whether they will actually stop or not. I thnk they know the truth, which is if they stopm they risk interest rates spiking. If that happens it it completely game over. They are better off keeping QE going and sweeping inflation under the rug. Until they can't at which point we hear a lot more "no one could have seen this coming".
That's the way I see it... or at least what I always come back to at the end of any scenerio I try to imagine. I think history will show that Bernanke was a very clever man. I think history will also show that he (we) could not outrun the mathematics in the end.
That is how I see it too.
Now in the mean time, the Fed will pull some levers over here, smoke will appear, and the sheep will go "...ohhhh....ahhhhh...." They will pull some levers over there, smoke will appear, and the sheep will go "...ohhhh....ahhhhh...." Classic misdirection, not a an exit BK.
In the end, the Fed cannot escape exponential functions and arithmetic: that is their black hole and they are past the event horizon. There is no turning back.
Interesting report, Bruce. Wonder what Treasury thinks about this assertion from the Fed:
The Federal Reserve paper states:
'Accounting rules' that the Fed just made up by themselves, maybe yesterday, and probably without any explicit statutory authorization.
In other words, if I were Sec Treas, I'd tell the Fed 'Screw your cockamamie carryforward; we need the bleeding cash, and the law says it's ours. Hand it over, chumps!'
"Existing Statue" you say. By this you mean a specific law that was passed by Congress. "The Law of the Land".
No, I don't think there is any "law" on this. Several years ago the Fed sent letters to congress that established how the accounting worked in the event of a loss. (I can't find those letters - If someone has them please post the link)
The 1/2013 report says. "The Fed's accounting is Consistent with GAPP". I think that is the only legitimacy for the Deferred Asset solution to a loss. The damn accountants set the rules on this, not congress.
If it ever came to a vote in congress, this accounting would never pass. Too flaky....
How on earth is a deferred owing (to the 3rd party named Uncle Sam) an ASSET? Isnt it more like a dividend payable?
Also, given those projected losses (and yes I realize they're unrealized) of $300B, that suggests under any plausible normal interest rate scenario, the Fed is insolvent -- given it has just $70B in capital. Well, I suppose it stands to reason that Uncle Sugar's banker would bankrupt...HE certainly is.
May we have a show of hands that voted us into the position?
They do what they please and dump the cosequences on the lowly taxcow. The middle class will bear the costs as the 47% don't give a damn, and the .01% are in the TBTFgains.
My sentiments precisely, Bruce.
Seems like the Fed is just staking out a bargaining position in advance, before they butt heads with Treasury a few years down the road.
A 'modified limited hangout,' as Nixon's plumbers would have called it. ;-)
Good question.
will the fed overshoot or the market? my guess is the market. which will force the fed to step in and buy. we know where that goes.
OT, but maybe not so much.
Why am I suddenly getting ads for body armor?
THe end of QE? Good luck with that hope and change. removing the punch bowl? Does anyone actually believe what the gov or fed say? why would you pay the least interest in their press? maybe if you wanted to know what misdirection looked like.
Welcome to the FED doom loop.
the Fed interest paid and gains/losses and treasury nonsense is just that. only the US media could report that the government is making money from printing it. Truely a magic money machine.
No one else really is buying US debt anymore (maybe the california teachers pensions fund). Remember only the fed is now buying the treasury's. The issue is that if interest rates rise to the level at which a free market would clear (or any sane individual investor would want to buy this Tbill paper) then the interest on the US debt rises at about the same rate or higher and the fed has to print at the same rate or higher. And we have a doom loop.
and if by some miracle the economy were to actually start growing and ignite classic measured inflation (toothpaste as opposed to taxes, or houses, or stock markets) and the fed somehow had to remove the punch bowl, you would have all that and growth removed by interest spikes. another doom loop.
and if you just keep printing and no growth then you have stagflation - another dooom loop.
So the printing must continue (m2 up 2% in december). the only thing to read into this is that there is inflation going on- its just not in any press release from the BLS, and the Fed knows it and they are exploring exits and discovering doom loops. but whether or not they get this doesnt matter - the fundamentals are still in place. Remember also these interest rates are the lowest recorded in all documented interest rate history(350 years back to UK in the mid- 1600's). Ben has built the opposite of an anti-fragile system.
Welcome to Ben's life in the doom loop.
It's the chatter! Pay attention to the chatter!
Why is there chatter now about "normalizing interest rates"? Why is there chatter about "ending QE?"
Damn, first they expand the money supply, and then they contract it.
But it's all inscrutable. Watch Abe.
To defer IS their mandate.
Just like the LTRO repayments yesterday, I think that hints/actions from the Fed towards canceling QE will initially be seen as bullish by the market -- a sign of normalization. However, it will be a disaster for Bonds/Fixed Income which could rapidly put us right back into another global financial crisis. I always thought that there would be one more crash before the paper currency collapse -- sooner than this but the Fed/ECB/BOJ interventions have kept delaying it.
Now that they are commited to printing to block any downturn it seems like the obvious thing to do would be to keep printing - the course they are on. It's obvious to us here that the Fed can never unwind now without a disaster in bonds, but it was also obvious to most of us that housing was in a bubble in 2006. These things might not be so obvious to the Fed. Certainly the bond bubble doesn't seem to be on their radar right now. Of all the actions possible to increase the severity of the final collapse, a prolonged period where huge govt debts are run up supported by money printing, only to end in another liquidity crisis when the Fed stops easing seems to be the worst. It's almost like someone is making sure there are no solvent institutions anywhere when the next crisis hits.
Turns out that the Pennsylvania elementary school that suspended the little girl for bringing a "Bubble Gun" to school, was rathher prescient. If that toy could actually destroy bubbles, it could have threatened the entire western worlds financial system.
Great find Bruce, but mark to market, and all the banksters "profits" go poof.
A half trillion dollar swing in 3 seconds, not years. And that will be just the start.
And the blackiest "Black Swan" will emerge to reek economic damage of the !st Magnitude.
The beginning of the troubles of thrift crisis in the 1980's was hidden in plain sight with the Federal Home Loan Bank Policy of permitting the deferral of losses on loan sales (as an asset) by thrifts when rates ramped up and they needed liquidity. It looks like some of the Federal Home Loan Bank people are now at the Fed.
which led straight to failure of Continental Illinois in the former case and the totality of Wall Street in the latter (meaning i agree with what you just said.) The fact is "everyone has a bailout"...especially when they don't. "It's the lie that saves them from having to do their due diligence." Not that the bailout didn't exist...amazingly it did. Having said that before i'd go re-inflating bubbles i'd want to know "what does the Heat Map look like this time" as these failures were long in the making...and obvious to those who were going to make them happen and thus make money off the whole thing (the Big Short.) What a friggin' scam. At least the Republicans are smart enough to understand that the higher the taxes the more the bailout tycoons risk. If I were the President i'd be ramping UP the war effort not trying to walk it back. "Let's see these phuckers try and make their ill gotten gains on the long side" for a change.
we know that Feds balance sheet makes it especially prone to rising rates, but these details are fresh insight but ultimately isn't plan B to remit all their bad paper to whence it came, the UST, and let the taxpayers deal with it? before 2008 there was a bit of talk about whether the GSE's really had government backing, (turns out their paper did, but their stock didn't) we can see the Feds balance sheet imploding, (their stock), but their paper is ours to keep (unless of course you believe that a few Congressmen who can't even make the Presidents party present a budget would make an end run to firewall off the Feds bad assets, which will never ever happen in a crisis, which is why it will never happen - hint: they can manufacture a crisis faster than a foreign war)
The land of the Big Lie.
Where's that Congressman who yelled out to POTUS, "You lie!"
Send him to the next FED press conference.
The money is made up, the FED's monetization which is technically not monetization but surely is, as clear as day it is, is all a convenient fiction. When the fiction is found out, or enough holders of Treasuries / FRNs recognize the fiction as no longer tenable, then there will be massive problems.
But the FED's balance sheet? Who is the FED anyway? If they suffered an infinite loss, would it matter? Same rule above applies, revert back to the fiction. An infinite loss would probably uncover the fiction and then there would be massive problems.
I don't think you can look at the Fed's balance sheet like you would any other entity. When you can create "magic money", what is a loss? The Fed has no real cost basis in any of its assets. How much does a digit cost to create?
That is why it is all accounting games over at the Fed. The bigger issue isn't really at the Fed, it is what does it mean for the rest of us where the digits do have real value?
Wrong. A loss at the Fed quickly turns into negative cash flow, which has to be made up by the last of the taxpayers. Remember us? But more to your point, it would scare the shit out of bondholders, and bring the Ponzi to a screeching halt.
WHo are these bond holders? It certainly isn't me.
Oh ... right ... the Fed is.
The Fed will not be worried.
Negative cash flow where? I understand the Treasury payments stop, but what cash flow are you talking about?
Like any other failing bank, and the Fed is a warped kind of bank, when interest expense exceeds interest income, real cash has to come in to balance the flows or bankruptcy and hilarity ensue.
The best model for this is the S & L disaster of the eighties. Lending long and borrowing short in a period of rising rates will wipe you out in short order, pretty much regardless of "size".
Who is going to bail out the Fed?
The IMF/World Bank. And wait 'til you see the conditions on the loan(s)!!
When interest expense is greater than interest income they print the difference. You can't break an entity that creates money. That is the whole deferred asset point.
The treasury has the ability to print, the Fed has the ability to BORROW.
WHEN NOT IF, the treasury begins to print, there will be hyper-inflation that will rip the faces off the banksters and the criminal classes in DC.
@kaiserhoff "The treasury has the ability to print, the Fed has the ability to BORROW."
All the time I always think that it is the FEDERAL RESERVE that has the ability to PRINT (both physically and digitally) while the Treasury has the ability to BORROW.
Not sure whether such differentiation does really matter, for all the parties involved there (incl. the POTUS. the Blue><Red team CONs, the Unjust life-time s-court appointees, the blood-thirsty generals at the helm, and countless other crooks/tools/organs/apparatchiks/accomplices/etc) are indeed chasing own self-interests serving the same ultimate PUPPET MASTERS (directly or indirectly). The naked games of "REVOLVING DOOR" themselves are already spectacular! We're witnessing the gang of THE BROTHERHOOD are all well positioned for the greatest con game ever played on Earth! What we are all seeing is just a mammoth MUPPET SHOW, only the show is getting UGLIER and CRUDER over times...
http://www.youtube.com/watch?v=qgce06Yw2ro
You lie, Rufus.
An end to QE? I can't even imagine that.
@ "An end to QE? I can't even imagine that."
Who will buy my pretty balloons??
The Fed can only stop QE when Congress cuts spending. The Fed's first mandate is to monetize treasuries.
the fed is the middle man between UST and the banks. the fed tries to control economic activity, while the private sector also monetizes debt, and you could argue was going a lot faster than the fed when 2008 happened. in a perfect world i guess the private sector would be the only source allowed to monetize federal debt. if Congress cut spending, it would only be a matter of time before private enterprise stepped in to to fill the void, but the reason we have a fed is that the government didn't want JP Morgan to set interest rates. fed believers will argue that they are goat roping the highs and lows out of the business cycle, to make a pretty patty world for everyone. that of course is bullshit, there have been more financial catastrophe because of the fed, but they really don't want the private sector calling the shots and wheneven there is a hiccup they are right there bitchslapping a few of their banker friends into bank-ruptcy.
I don't think "the government" created the fed to protect us from J.P. Morgan. Quite the contrary in fact.
Check out The Creature From Jekyll Island.
in the original document, congress has control of the money supply, in the abbreviated modern policy, the fed controls the money supply. providing cash is only the effect, debt is monetized, and that is the cause, (and the loans are actually) then money has to be printed.
the private sector also monetizes debt, outside the control of the fed, unless you consider the Feds ability to change lending rates, and reserve requirements. happy that they were keeping interest rates in check, they inadvertently fueled the housing bubble, and the money supply threatened to get away from them again ( or you could say that the private sector taking the feds priopriotary monetization. which is used to feed their spending habit, was being taken away).if old JPM had been around he would have raised rates on the mortgage sector because the market could bear it, demand was surging. and of course the fed didn't want that, so either way to care to view it, the fed is an extension of the political encumbency, sworn to maintain money for THEIR spending needs, which is why we have a 99% government economy right now. if only some banker could raise those lending rates, but of course the fed is the 800 lb gorilla.
CLUSTERFUCK : military origin. Commonly used to descriptively generalize any situation with a large scale of disarray.
Just remember - Japan implodes first.
On the other hand, you know what they say about the first casualty of war.
Hint - ZE BATTLE PLAN
Not to worry, the gains on Treasuries should be more than offset by the losses on the MBS it is buying at full face value, whereas they are actually only worth about 10 cents on the dollar.
Closer to 5 cents on the dollar.
90% of the REMIC trusts are hollow trash.The ones the FedRES buys are sure to be stuffed full of
non performing 'selected' promissary Notes.
stop looking behind that dang-blasted curtain! - Oz
Boris is not recall life behind curtain for much favorable.