05
Jul
2013
The Fed’s Equity
Given the recent rise in Treasury yields, I asked Caitlin Long (an Austrian at Morgan Stanley) if they had reevaluated the Fed’s equity. She said (and gave me permission to relay to you folks) that as of mid-June, just over half of the mark-to-market cushion remained. That means an additional 80bps shift in the yield curve from June 15 levels would wipe out the remaining mark-to-market cushion.
Well, eye-balling to today’s big move I see the 10-year up ~45bps since ~ 6/15 and the 30-year up ~ 30bps from ~ 6/15..
What gimmickry can it employ to stop that?
Who cares?
Not everyone is as enlightened as you, Blackadder. Some investors might flee the dollar if the Fed becomes insolvent.
I apologize for my ignorance, but can you explain how a central bank can theoretically become insolvent? Thanks
I am also interested in this question. For those who might be concerned about this, what theoretically from their point of view is the reason?
If there are no saleable assets, it means the money supply can only grow and not shrink. The inability to unwind implies a loss of control over the money supply. Even the Keynesians stipulate that a central bank’s job is create stable prices and high employment. Without the ability to sell assets to soak up liquidity, how can stable prices ever be achieved again?
Government could do it by raising tax and cutting spending… but this would require the political will to make that happen.
What’s the mark-to-market cushion? Do I understand you right that you’re saying that if interest rates go up 80 basis points, then the bonds the Fed holds will lose enough value to put the Fed in negative equity?
Yes that’s what the Morgan Stanley analysts are claiming.
I know I wouldn’t worry about any “negative equity” if I had a money printing machine in my basement.
But investors in your scrip certainly might become concerned — if you not only do not have the will at present to unwind your policy, but no longer even possess the market power to do so since you have nothing of value to sell to ‘soak up excess liquidity’ and thereby quash rising prices!
They can always unwind their position at a loss, anyone can do that. A loss to the Fed would imply that money has entered circulation (i.e. a nett gain to everything other than the Fed) but let’s face it, we already know that new money has entered circulation, we just don’t know where it is circulating to.
But all this talk of unwinding is presuming that the US government is going to stop borrowing — very difficult to imagine. Since government borrowing is the heart of the problem, the real question is whether the Fed has the guts to force higher interest rates onto all the NEW government borrowing, thus increasing the percentage of tax that gets soaked up into interest payments. That’s when the rubber really meets the road and we find out whether political power beats banking power.
But that wouldn’t be an example of negative equity.
The Fed won’t become insolvent, either on paper or in reality. It’s holding a very valuable asset which doesn’t appear on its balance sheet – its currency (i.e. $100 bills) monopoly.
There’s also the fact that the Fed’s owner has deep pockets. But the Fed won’t ask for a bail-out, or need one.
Which any future government could deprive them of at any time, indeed with things like Bitcoin it may just happen all by itself.
Max, if Treasury yields rise by about 50 bps across the board, then the Fed will be insolvent. You’re saying this won’t happen even “on paper.” How does its monopoly prevent Treasury yields from rising?
Don’t worry, “mark to market” accounting was abandoned years ago, hold the rotten asset and never sell, just tell the shareholders it’s all cool because you keep the asset on the books at the peak value.
The entire US mortgage industry runs this way… so how could it be wrong?
Well, to be honest, at this point the Fed *is* the entire mortgage industry.
Murphy, I read your Mises article that walks the reader through some hypothetical Fed balance sheet scenarios, where you show that technically speaking, the Fed could become insolvent (where you note that in practise, because it can print money, insolvency would not be a reason for it to cease operations, unlike Acme Bank).
Yet even from a purely accounting perspective, shouldn’t you have included the present dollar value of “the ability to print money” on the asset side of the balance sheet? You included Treasuries as the Fed’s only asset, but the Fed is not in business to be a Treasury investor. It is in business to print money. That has value, and so shouldn’t any accounting of the Fed’s assets include that in addition to Treasuries?
If you’re curious about the accounting…
http://www.federalreserve.gov/pubs/feds/2013/201301/201301pap.pdf
“Federal Reserve Bank accounting rules stipulate that when income is not sufficient to cover expenses, remittances to the Treasury cease, and the Federal Reserve books a ‘deferred asset’….The deferred asset is subsequently realized as a reduction of future remittances to the Treasury (which are accounted for as interest on Federal Reserve notes expense).”
In plain English: the Fed withholds its profits from the Treasury until past losses are covered.