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Does Interest Rate Risk Matter If You’re the Fed?

Wednesday, November 28, 2012

Holding a mortgage investment portfolio bigger than Fannie Mae’s or Freddie Mac’s, along with a massively expanded government bond portfolio, puts the Federal Reserve into uncharted waters of interest rate risk.

The combined balance sheet of the Federal Reserve has $2.9 trillion in assets and $55 billion in equity, for leverage of a heady 52 times and a capital ratio of a paltry 1.9 percent. On top of this high leverage and little capital, the Fed runs massive interest rate risk, with investments in long-term mortgage-backed securities (MBS) of over $900 billion and longer-term Treasuries of $1.65 trillion.

“The huge and rising government bond holdings of Japanese banks leave them vulnerable to a spike in interest rates, the International Monetary Fund has warned,” the Financial Times reported recently. But somehow the IMF did not warn about the Fed’s huge and rising bond holdings, which leave the Fed vulnerable.

A rise in interest rates from their historic lows is inevitable at some point. How vulnerable is the Fed’s balance sheet to interest rate risk? We can estimate the market value impact of a 2 percent increase in interest rates, a common benchmark.

The Fed has announced it will be adding $40 billion a month to its $900 billion in MBS, so it’s fair to consider that in a few months it will own $1 trillion in these mortgage securities. A reasonable estimate is that a 2 percent increase in interest rates would reduce the value of long-term fixed rate MBS by about 15 percent. On $1 trillion of mortgages, this would be a hit to the Fed’s market value of about $150 billion.

The $1.65 trillion in longer-term Treasuries probably has an average maturity of at least five years. A reasonable estimate of market value loss on this position for a 2 percent increase in interest rates might be 10 percent, or $165 billion.

The total loss to the economic value of the Fed’s aggregate balance sheet would therefore be about $315 billion, compared to total capital of $55 billion. The Fed is thus vulnerable under this reasonable scenario to market value loss of over 5 ½ times its total capital. Of course, to the extent that the securities were sold in this scenario, the market value losses would become cash losses.

What difference would it make for a fiat currency-issuing central bank to be deeply insolvent on a mark-to-market basis?

A question whose answer we know is: what would an ordinary bank examiner say to a financial institution that had the same interest rate risk position relative to its capital? It would involve the institution being characterized by a lot of unflattering, not to mention threatening, terms.

Questions whose answers we do not know are: What difference would it make for a fiat currency-issuing central bank to be deeply insolvent on a mark-to-market basis? Would anybody care? Would the bank’s liabilities still be considered riskless assets for others? Would you worry about accepting a $100 bill? Presumably the Treasury will always support the Fed to any extent necessary, while simultaneously the Fed will always support the Treasury.

Would large market value losses affect the market perception of the Fed’s capital? The stock of the Federal Reserve Banks is held by commercial banks. If interest rates went up 2 percent and the Fed had a consequent mark-to-market net worth of negative $260 billion, would that affect the commercial banks’ calculations of the value of their investments in Fed stock? The Federal Reserve Banks have a call on the commercial banks for additional stock investment — would the Fed ever need to issue a capital call? They would not — see the accounting discussion below.

Would the Fed have market value gains on gold to offset the bond market losses? No: the Fed does not own a single ounce of gold.

One clear response from the Fed to the possibility of such immense market value losses is that they would not matter because the Fed does not keep its books on a market value basis, so its book capital and book earnings would be unaffected. This is true. Under Federal Reserve accounting principles, the Fed accounts for its securities at amortized cost, not at fair value.

“Amortized cost, rather than the fair value presentation, more appropriately reflects the Reserve Banks’ securities holdings given the System’s unique responsibility,” is the Fed’s judgment, as expressed in its “Significant Accounting Policies” note to its financial statements. “Unrealized changes in value have no direct effect… on the prospects for future… [Fed] earnings or capital,” it adds. This last statement was drafted at an earlier time and with the current Fed balance sheet is probably not true.

Is there any risk that the Fed could lose the protection of this accounting treatment? No, because the Fed sets its own accounting policies. These are defined in the Financial Accounting Manual for Federal Reserve Banks, which the Fed writes itself, and of which Chapter 4 covers “Central Bank Unique Accounting.”

If the Fed had a loss equal to its total capital of $55 billion, its capital would not be reported as zero, but would remain as $55 billion.

Speaking of unique accounting, the Fed goes even further. Under an accounting policy set by the Fed in 2011, if the Fed had losses, they would not reduce book capital. The net loss debit, instead of going to the capital account, would go to the "Interest on Federal Reserve notes due to U.S. Treasury." In other words, if the Fed had a loss equal to its total capital of $55 billion, its capital would not be reported as zero, but would remain as $55 billion. There would be a $55 billion “deferred asset.” If the Fed lost $100 billion, its book capital would still be $55 billion. Get it?

Does interest rate risk matter if you’re the Fed? It’s not that clear. But it is clear that holding a mortgage investment portfolio bigger than Fannie Mae’s or Freddie Mac’s, along with a massively expanded government bond portfolio, does put the Fed into uncharted waters of interest rate risk.

Of course, this is in response to the effects of the great 21st century bubble. It all puts into wonderfully ironic perspective this commentary of 99 years ago: “when the new financial regime is in running order,” opined the American Banker about the Fed on December 27, 1913, “there will be supreme satisfaction with the thought that from this time forward the financial disorders which have marked the history of the past generation will pass away forever.” One can wonder whether the author of that supremely wrong prediction would feel “supreme satisfaction” with the Fed’s balance sheet of today.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.

FURTHER READING: Pollock also writes “The Financial Stability Oversight Council’s Fatal Flaw,” “The Tragic Demise of Fannie Mae,” and “Geithner’s View from the Top of the Bubble.” Blake Hurst discusses “The High, High Cost of Low, Low Rates.” John H. Makin says “The Fed Takes a Gamble” and has, “Upon Reflection, Second Thoughts on QE3.”

Image by Dianna Ingram / Bergman Group

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