The Black Swan Rears Its Head: The Fed Has Negative Capital Using GAAP Accounting

[Gunnar Larson]

https://wallstreetonparade.com/2024/04/the-black-swan-rears-its-head-the-fed-has-negative-capital-using-gaap-accounting/


By Pam Martens and Russ Martens: April 11, 2024 ~

Federal Reserve Building, Washington, D.C.The Fed’s unprecedented
experiments with years of ZIRP (Zero Interest Rate Policy) and QE
(Quantitative Easing), where it bought up trillions of dollars of
low-yielding U.S. Treasuries and agency Mortgage-Backed Securities (MBS)
and quietly parked them on its balance sheet, are now posing a threat to
the Fed’s flexibility in conducting monetary policy. (Since 2008, the Fed’s
concept of conducting monetary policy has come to enshrine serial Wall
Street mega bank bailouts as a regular part of its monetary policy. Large
and growing cash losses at the Fed may seriously crimp such future
bailouts.)

As of last Wednesday, according to Fed data, the Fed was sitting on $6.97
trillion of debt instruments it had predominantly purchased at very low
fixed rates of interest. Because the interest rate (coupon) is fixed for
these past purchases, when new bonds are issued in the marketplace at
higher interest rates, they become more attractive and the current market
value of the low-yielding fixed-rate bonds fall. U.S. Treasuries and agency
MBS guarantee principal at maturity but if the securities have to be sold
prior to maturity they will be sold at their current market value. This is
what triggered the death spiral at Silicon Valley Bank in March of last
year.

Silicon Valley Bank announced that it had sold a $21 billion bond portfolio
(that was yielding less than 2 percent when current interest rates on notes
and bonds were twice that amount). It reported a $1.8 billion after-tax
loss on the bond sale. Losses negatively impact capital. The hit to capital
panicked the very large amount of uninsured depositors at the bank (those
holding more than the $250,000 the FDIC insures per depositor, per bank)
and triggered an unprecedented bank run in terms of speed and scope.
According to a report from the FDIC, Silicon Valley Bank had deposit
outflows of $40 billion on March 9, and another $100 billion of deposits
queued up to leave on March 10 – which together would have been 85 percent
of the bank’s deposit base. The FDIC had to step in as receiver and take
over the failed bank.

Compared to the Fed, Silicon Valley Bank was a minnow. At the time of its
failure in March 2023, Silicon Valley Bank had $212 billion in assets. As
of last Wednesday, the Fed had $7.4 trillion in assets. Just one of the
Fed’s 12 regional Fed banks, the New York Fed, is 18 times the size of
Silicon Valley Bank.

According to the Fed’s latest asset breakdown, as of April 3 the New York
Fed, which is by far the largest of the Fed’s regional banks, has $3.88
trillion in assets and $2.77 trillion in deposits.

Unfortunately, using GAAP accounting, both the Fed itself and the New York
Fed have negative capital. And if interest rates continue to rise in
response to inflationary pressures, that situation could get much worse. As
the chart below indicates, as of December 27, 2023, using GAAP accounting,
the Fed had negative capital of $82 billion while the New York Fed
represented $69.6 billion of that negative capital, or 85 percent. That’s
before taking into account the approximate $1 trillion in unrealized losses
on the Fed’s portfolio of underwater debt securities. The final column on
the chart below reflects that calculation. (The Fed does not mark its
securities to market, on the basis that it plans to hold them to maturity.)

In January, two researchers, Paul Kupiec and Alex Pollock, put the capital
problem and operating losses at the Fed into sharp focus with a report
published at the think tank, American Enterprise Institute (AEI).

Kupiec is an exceptionally well-credentialled senior fellow at AEI. Prior
to joining the think tank, Kupiec was an Associate Director of the Division
of Insurance and Research within the Center for Financial Research at the
FDIC, where he oversaw research on bank risk measurement and the
development of regulatory policies such as Basel III. Kupiec was also
Director of the Center for Financial Research at the FDIC and Chairman of
the Research Task Force of the Basel Committee on Banking Supervision.
Other prior posts included work at the IMF, Freddie Mac, JPMorgan and at
the Division of Research and Statistics at the Board of Governors of the
Federal Reserve System. Kupiec holds a Doctorate in economics — with a
specialization in finance, theory, and econometrics — from the University
of Pennsylvania.

Pollock is a Senior Fellow at the Mises Institute and also
well-credentialled. He previously served as Principal Deputy Director of
the Office of Financial Research (OFR), the federal agency created under
the Dodd-Frank financial reform legislation of 2010 to keep federal
regulators on top of potential risks to financial stability. Pollack was
also the former President and CEO of the Federal Home Loan Bank of Chicago
from 1991 to 2004. Pollock is a graduate of Williams College, the
University of Chicago, and Princeton University. His latest book, which he
co-authored with Howard B. Adler, is Surprised Again! — The Covid Crisis
and the New Market Bubble (2022).

The researchers write:

“Notwithstanding the claims made by current and former Federal Reserve
officials, the Fed’s cash operating losses and unrealized interest rate
losses have already changed the way the Fed conducts monetary policy. In
the past, when the Fed wanted to raise rates or shrink member bank reserve
balances, it would sell SOMA [System Open Market Account] securities. But
today, with the market value of its SOMA securities approximately $1
trillion less than their book value, selling these securities would
immediately turn huge unrealized mark-to-market losses into actual cash
losses. To avoid reporting such embarrassing losses, the Fed has committed
to hold these securities until they mature to ‘avoid’ a loss, thus
constraining its monetary policy options.

“The Fed’s official plan is to shrink the size of its balance sheet by
letting its SOMA securities mature over time. But if interest rates stay
elevated, the Fed’s unrealized market value losses will systematically turn
into cash operating losses because the Fed will keep paying more to finance
its securities than the yield it earns on SOMA securities. FRBs’ operating
losses could continue for a long time.”

The bottom line is that the Fed, as Emperor of monetary policy, has
threadbare garments. It’s left with only a confidence game. Kupiec and
Pollock explain that as follows:

“As long as the public and financial market participants retain confidence
in the FRB’s unsecured deposits, FRBs [Federal Reserve Banks] can continue
to pay banks billions in interest and dividend payments while operating at
a loss, deeply technically insolvent, and with asset shortfalls. Aided by
an implicit guarantee, taxpayers will bear the burden of accumulating
Federal Reserve losses that are hidden by Federal Reserve accounting
policies and not included in reported government deficit statistics.”

Maintaining confidence in the Fed has already come at a serious price,
including censored reporting by mainstream media. That’s something the
American people should think about very carefully. (See There’s a News
Blackout on the Fed’s Naming of the Banks that Got Its Emergency Repo
Loans; Some Journalists Appear to Be Under Gag Orders. See also: Reporters
Who Ask Tough Questions at Fed Press Conferences Have a Habit of Being
Disappeared from the Room.)
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