By: Phil Kernen
The Federal Reserve has been the biggest bond buyer in the U.S. Treasury and Mortgage-Backed Bond markets for the last decade, expanding its balance sheet from about $800 million to more than $8 trillion. So long as inflation remained low, its actions produced a slowly growing economy by keeping interest rates and unemployment low. Now that inflation is at its highest level in forty years, and the Federal Reserve is starting to raise interest rates in response, the financial condition of the Federal Reserve could get ugly.
SOMA, an acronym for System Open Market Account, is used by the Federal Reserve for all its open market operations, including purchasing and selling domestic securities and foreign currency. Every bond purchased goes into the SOMA. Unlike public (and many private) businesses, including banks it regulates, the Federal Reserve does not follow Generally Accepted Accounting Principles (GAAP). The Fed follows its own rules to defer any unrealized gains or losses until selling securities.
As the SOMA grew and interest rates fluctuated, the value of those same bonds moved. After 2008, interest rates generally followed a downward trend that started in the 1980s; the unrealized gain in SOMA bonds was positive, reaching $400 billion in 2020. However, two short periods of rising rates in 2013 and 2018 led to net unrealized losses of approximately $60 billion at the Fed. It closed out 2021 with an unrealized gain of $128 billion.
Analysts blamed the Great Financial Crisis on increasing leverage in the financial sector or the weakened ability of financial firms to weather the rapidly declining value of mortgage-backed securities. The truth is that financial companies have almost always been highly leveraged relative to other sectors. During 2007-09, leverage peaked around 30-to-1, meaning one dollar of equity supported $30 of borrowed money. With 30-to-1 leverage, a relatively small 3% loss could wipe out bank capital entirely.
In an ironic twist, the Fed purchased bonds with borrowed money. Following four rounds of bond buying programs, the Federal Reserve has an $8.5 trillion bond portfolio supported by a capital balance of $48 billion or leverage of 176-to-1. Made up mostly of fixed coupon U.S. Treasury Notes and Mortgage Backed Securities, rising rates cause these bonds to be worth less. For the first six months of 2022, while the Federal Reserve raised interest rates by 1.5%, its $8.5 trillion bond portfolio suffered, by our estimates, an unrealized loss of $850 billion, or a loss of -10.25% and 17x its capital. The Fed is technically insolvent.
Leads to problems
Following the accounting rules adopted by the Fed, unrealized losses will only appear on supplemental disclosures; they will never post them to the balance sheet. However, as they grow more significant, problems will arise. The first is political, as members of Congress realize that the Federal Reserve is sitting on assets worth less than their purchase price by $850 billion or more.
The second problem is more practical. The Fed wishes to sell precisely zero of these bonds, preferring to reduce its balance sheet by allowing bonds to mature without reinvesting the proceeds. Yet the odds are growing that simply raising rates will not be enough to arrest inflation to the desired degree. Reducing the SOMA account balance will be required, necessitating some sales, realizing losses, and exacerbating the first problem.
The third problem affects operational flexibility. The Fed adopted accounting standards to manage its unique organizational status. But suppose inflation pressures force them to start selling off their assets. In that case, they won’t be able to ignore the resulting losses for long, limiting the availability and usefulness of monetary tools at their disposal.
The final problem is cash flow. Since 2007-09, a growing balance sheet has left the Federal Reserve increasingly profitable on a cash flow basis. Remember that the Federal Reserve receives interest income on its assets, the $8.5 trillion bond portfolio. And it pays interest on much of its liabilities, $5.6 trillion in reverse repurchase agreements and bank reserves. The rest of their liabilities is the cash in the economy. The Federal Reserve remits profits back to the U.S. Treasury, more than $100 billion for 2021.
The coupon interest earned on its bond portfolio is relatively low and fixed. In contrast, interest expense on its liabilities floats and increases each time it raises interest rates. The more the Fed raises interest rates, the less profitable it becomes. Our analysis suggests that the Federal Reserve will pay out more interest expenses than it takes in once the overnight rate moves to 2.25%. We are at 1.75% now and moving higher. Following recent inflation reports, it is increasingly likely rates will need to move at least to 4% and possibly higher to get inflation back under control.
Too much leverage always involves consequences, and the costs are becoming apparent for the Fed. The income boost from the Federal Reserve to the U.S. Treasury income is likely over. Given its current financial state, needed changes could minimize expected operational losses. Ideas could include cuts in the interest paid on liabilities, higher reserve requirements for banks on which the Fed pays zero interest, or reducing the balance sheet faster by selling bonds and realizing losses. None of these options is perfect, and all include material downsides.
In the extreme, the fund flows could reverse. Though it is improbable, imagine Fed Chairman Jerome Powell going hat-in-hand to Treasury Secretary Janet Yellen and Congress asking for a couple hundred billion to rescue his balance sheet. More to come.
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