The Fourteenth Banker Blog

December 15, 2010

That Didn’t Take Long

Filed under: Running Commentary — thefourteenthbanker @ 5:59 PM

Two days ago I posted on some comments I heard on C-Span about the Fed taking on interest rate Tail Risk. The particulars were that if rates jumped 25-50 bps, the market value of the Fed’s holdings would drop by a sufficient amount to wipe out their capital.  Yesterday rates jumped, and Zero Hedge posted this.

Today we get a brief glimpse of what will happen to the Fed’s balance sheet when rates surge. In the span of one day, the Fed took an $8 billion unrealized loss on its $1.07 trillion in Bonds, TIPS and Agencies. It also likely experienced a comparable loss on its MBS portfolio. It’s a good thing the Fed has $57 billion in capital accounts. Which means 4 days like today, and all of the Fed’s equity buffer is wiped out. What happens next is up to congress.

Today rates jumped again on the long end of the curve with the 30 year Treasury jumping 8 bps and 10 years jumping 5 bps.

The Fed does not mark-to-market, so it is not insolvent.  But, it bought these assets at market value at times when it was working to suppress interest rates and therefore prop up bond prices.  With rates moving, the assumption of this risk is panning out as planned. It is an unaccounted for gift to those from whom the bonds were purchased.




  1. One might get a very cute about all this. Me anyway. How to twist it all just for the sake of twisting it all. The FRB’s bought the MBS’s at par , from Member Banks, presumably under legal contract, as a credit to the Member Banks Demand Reserve Deposit account at theur FRB. The FRB could , at any time, forward their contracted consideration for the purchase to the member bank. That would be duly validated and issued Federal Reserve Notes. At the same time, the FRB’s could offer the MBS’s for sale over time . The consideration would be received in live funds that the FRB could maintain at any member bank to the FRB’s credit. The FRB demand deposit at any member bank would not be offset against the bank’s claim against their FRB. It would be zero antway since they received currency . Transaction settled. While technically , losses would be recorded for the MBS sales…. the bank funds on deposit would be a solid asset. Now,certainly the banks would wind up returning the excess currency they cannot circulate. The effect would be a permanent increase in the banks Reserve Deposit at the FRB or until such time as the member bank finds a way to take back currency for placement somewhere. Maybe sell it at a discount to the gangsters?

    But look at the balance sheet. Maybe $700 bn in demand deposits at member banks. A loss of $300 bn turning the FRB’s into a Capital Deficit of $250 bn. Then look at the liabilities due against Treasuries, Agencies, Gold Certs and Demand Deposits of say $%1,800bn of no more than $300 bn in real terms . And that includes the Treasury Suplementary Deposit of $200 bn which could be currency too.

    Thus the insolvent FRB’s have around $1800 bn of assets and only real claims due of $300 bn . Yet they are insolvent with a capital deficit of $250 bn . Just mental creation of numbers here to show the dilemma. This brings up the real status of the outstanding note liability account . In my quickie, around $2 trillion. That debt will never be paid unless the FRB’s are liquidated and the nation has no currency in circulation. The outstanding FRB liability is really a capital account due on liquidation of currency into the US Treasury for replacement as US Notes, but for a normal redemption range which is quite small . History supports this because the outstanding liability account has trended upward for 96 years. But , oh hell, leave $200 bn as a liability and the remaining $1700 bn is treated as a capital allocation … A kind of Paid In Surplus . That raises the equity of the FRB’s to around $1,500 bn.

    Just having fun here. I probably should not, but I think of the AEI Fellow as about on the par of a fellow at a west Arkansas bible college. I have heard it alleged that ideology is a form of illiteracy.

    I need to check in to this, it is so esoteric. But, I think FRB’s may make capital calls on Member Banks in the case of FRB solvency issues. So , the practical effect then would be that tha banks in two sets of transactions would wind up the same as having sold the MBS’s to the Treasury at a deferred market price now converted.

    Another research project would be to establish if the MBS’s were purchased subject to repurchase at par by the Member Banks from the FRB at the FRB’s discretion.

    Comment by Jerry J — December 15, 2010 @ 11:03 PM | Reply

    • Jerry, you write that the FRB could pay the member banks with old fashioned Federal Reserve Notes. Why cannot the FRB wire modern digital money? They can lend digital money but have to pay with notes???

      Comment by Jakob W — December 16, 2010 @ 3:36 AM | Reply

  2. There is no digital money at the FRB’s for use in settlement. Bank funds or live money are balance transfers between banks . These are funds already on the banks books as being owed the bank. Technically, there is no such thing as digital money. Banks wire transfers against and from each others balances to their credit or debit by wire advice. In the alternate, net transactions are settled by charging or crediting their Reserve Account at the FRB. The twelve FRB’s do the same through their interbank balances account . At the end of a period, these balances used to be cleared regularly by transfers of currency. There is only currency. All other funds are balances owed between the banks. Technically , these balances are cumulatively zero at the end of the day between all parties. There is however some float even today.

    Prior to the autumn of 2008, the total sum of Reserve Deposits averaged around $7 bn. The Reserve Deposit was immediately taken to zero unless there was reserve meeting deposits in the account of any member bank.

    The FRB , outside of some tricks that historically never amounted to more than a pittance, must take down their account in currency or take Treasuries . My post above was more satire than anything. However, I cannot concieve of the FRB’s buying the MBS’s on any other term of putchase tha settlement in currency. If they settled in Treasuries, by substitution, the MBS’s back the issuance of Federal Reserve Notes. That is political dynamite if not outright illegal. So, as I said, give the banks the currency to seetle up the MBS purchase. Then , be even more astutely foolish and sell the MBS’s on the open market. They would be paid in funds transfers from the purchasers banks and those funds would become demand deposits of the FRB’s in the member banks. Those deposits though are neutral because the receiving bank might lend out more and the paying bank would be able top lend less.

    But seriously, the FRB’s own Fannie and Freddie guaranteed paper. Any loss is made good by Fannie and Freddie to the FRB’s. The Treasury has credit lines out to F&F. Seriously, would the General Government of the United States allow a guarantee default to it’s own central bank? If it did, the government would fall financially.

    The present accounting credits the FRB’s with an equity of over $50 bn. A 5 % market loss would sophmorically reduce the FRB’s to Accounting 102 “Insolvency”. On the other hand, the Treasury is paid a theoretical interest on outstanding Federal Reserve Notes or around 98 % of the profits of the FRB’s. The profits substitution has been in place since 1947. That makes the outstanding FRN liability really a Variable Preferred Stock, err Equity in the real world . Practically, the liability will never be paid down. If that were to happen , the FRB’s would no longer be going concerns and would no longer issue going conern financial statements. Then there is the matter of capital calls from member banks.

    Then, the solution is to sell these MBS’s back to the banks as a charger against their Reserve Demand Deposit Account, which must have been contemplated in the first place.

    Comment by Jerry J — December 16, 2010 @ 12:45 PM | Reply

    • I could favor a sell back at the original price, since that was for purposes of providing liquidity backstop, and temporary price discovery, purportedly.

      Comment by thefourteenthbanker — December 17, 2010 @ 9:35 AM | Reply

  3. Jakob W., I should add that the FRB’s literally have almost no funds deposited in member banks. In the weekly statements, demand deposits are not even separately stated but are buried in ” Other Assets”. Even the FRB NY has only a couple hundred million of bank deposits. The FRB’s have no way to create electronic funds until Congress allows them to. I can just see the bill being sponsored by Ron Paul. Only the FRB’s may create electronic funds if allowed to by the sovereign. Think how profitable banking would be if they could create funds to loan out. They must get their funds the hard way:Lent to them by depositors.

    Comment by Jerry J — December 16, 2010 @ 1:05 PM | Reply

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