04 Jul 2014

The Fed Flirted With Insolvency in December

Federal Reserve 9 Comments

For a while now I have been warning people that even a slight rise in interest rates could render the Fed technically insolvent, because the market value of its assets would be lower than its outstanding liabilities. In terms of accounting, therefore, it would have negative shareholder equity.

Now in early 2011, there was a rule-change that would possibly rescue the Fed from officially declaring bankruptcy: In the event of a big capital loss emanating from a crash in the bond market, the Fed could conceivably argue that it owed the Treasury a negative amount of money. I walk through all of this hocus pocus here.

Yet this had all been theoretical. I was just made aware that back in December 2013, the Fed in practice came very close to actual insolvency (if it marked its assets to market). Specifically, as of 12/31/2013, the Fed reported equity capital of $55.0bn and unrealized portfolio losses of $53.3bn, meaning there was a net (mark-to-market) equity of $1.7bn supporting $4 trillion of assets. (I have seen an official auditor’s report with these figures, but I can’t find an online source to link you to.) That’s pretty leveraged.

If you want to think through what it “means” if the Fed literally goes bankrupt, read my earlier article. By no means will the government say, “Aww shucks, I guess we’ll get out of the fiat money business.” But it might spook investors and pop what I believe is our massive bubble in dollars and Treasury debt.

9 Responses to “The Fed Flirted With Insolvency in December”

  1. Transformer says:

    While not doubting the ability of the fed to screw things up in practice I don’t see why in theory the size or value of its balance sheet should be a problem.

    As interest rates increase it is true that the value of the feds assets could become less than its liabilities. If this freaked investors then this would likely cause inflationary effects as people try to hold less inadequately backed dollars. To counter this this fed would need to swap dollars for bonds . The result would be less dollars circulating and a smaller fed balance sheet. Wouldn’t this address the insolvency issue?

  2. Tel says:

    Yet this had all been theoretical. I was just made aware that back in December 2013, the Fed in practice came very close to actual insolvency (if it marked its assets to market).

    Mark to market is back again? Why wasn’t I told?

    On the liabilities side, the central bank has three major items. First, there are $500 billion worth of green pieces of paper held by the public, in their wallets and purses, home safes, and bedside piggy banks.

    It is indeed listed on the liability side, but it isn’t really a liability is it? I mean, the people holding those green papers don’t have an actual claim to anything. If I give out an IOU note, someone might come back and call me on it, but when the Fed gives out IOU notes you can’t. That’s the key difference.

    It’s important to realize that this last category of liability does not (currently) correspond to physical currency. The $250 billion that Acme Bank et al. have on deposit with the central bank consist entirely of electronic bookkeeping entries.

    Since transactions are settled electronically, you can indeed buy physical goods using those electronic checking accounts. They are every bit as physical as a green piece of paper (which is only a different technology for book entries and record keeping). Think about it, the paper is not valuable, what’s written on it is valuable.

    • guest says:

      Since transactions are settled electronically, you can indeed buy physical goods using those electronic checking accounts.

      Yes, the accounting is done electronically, like how tracking a package can be done electronically, but this doesn’t turn the things being accounted for into electronic currency.

      This is not an admission that paper notes are money, by the way.

      Also, what does it mean to say you’re “buying” something with something that is arbitrarily valued? I could “buy” something from you with a handful of dirt (dirt is physical, too), in the same way, if you chose to accept it.

      • Tel says:

        That’s just the point, if I chose to accept it. Not many people do accept dirt.

        At the moment a lot of retailers choose to accept electronic transactions, just about all of them do actually. This is what makes the electronic version of the FRN equivalent to the paper version.

        In terms of whether the FRN is worth something, it is a commodity money backed by violence. Americans must pay tax in FRN or else they get hurt (else they live sufficiently far outside the law that they either pay protection to someone else, or they look after themselves). This is what gives value to the FRN. Since electronic tax payments are acceptable, they have value for the same reason.

  3. Gamble says:

    Life will be grand when I can issue for myself unlimited debt…

  4. Kevin Donoghue says:

    “…the Fed in practice came very close to actual insolvency (if it marked its assets to market).”

    The Fed’s most important asset is a license to print money. Try marking that to market.

  5. Major.Freedom says:

    “The risk of normalising too late and too gradually should not be underestimated… The trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on .” – Bank of International Settlements

    Brainworm…hahaha

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