As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?
The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.
If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.
The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.
And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?
All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.
Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.
People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.
About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?
Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.
When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.
It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.
It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?