I was listening today to several American Enterprise Institute fellows on C-Span. They were discussing the recent revelations about the Federal Reserve programs and under what conditions the Federal Reserve might be considered insolvent. Isn’t it remarkable that such a conversation would even take place? The discussion was theoretical in that it is an accounting question. The Federal Reserve does not have publicly traded stock to serve as a barometer of its health. It does not have debt rated by anybody to help people understand the strength of it’s balance sheet (BS).
We do however know something about its assets and its financial statements are public. The speakers basically had two points to make in the segments I listened to.
First, the Fed does not mark its holdings to market. We do not really know what they are worth today or at a future point in time. Perhaps these holdings are not so far underwater on a market value basis to make the Fed insolvent if marked to market today. In any case, the incestuous relationship with the rest of USG means that the cross guarantees of Fannie, Freddie, and others protects the Fed’s assets to some extent. Of course, those guarantees are dependent on the borrowing ability of the US Treasury, which these days requires the monetization of debt by the Fed, the largest holder of Treasury debt in the world. So that all sounds pretty good.
The second point is that in taking on this TRILLION plus in MBS, the Fed has taken on a huge tail risk in that should interest rates rise, the bonds cannot be sold for as much as they can in today’s, or three weeks ago’s bond market. The AEI estimates that a 50 bps rise in interest rates across the yield curve would make the Fed insolvent on a mark to market basis. That may be as little as a 25 bps rise today. But so what? The Fed does not have to mark to market.
I guess my point is this. The Fed intentionally took on assets that create mark to market accounting solvency risk in a sufficient amount that a little tick up in interest rates makes those bonds worth sufficiently less to negate all the capital at the Fed. It took on a massive Fat Tail risk in these asset purchases? Why? To transfer wealth to the sellers of this paper, be they US banks, foreign banks, foreign governments. It was a transfer of wealth for the purpose of saving the financial system upon which the wealthy depend.
“Heckuva job, Bennie!”