Fed Solvency? Another False Fear

Recycled fears are a bull market hallmark, so it is no surprise to us that a retread from months past is back in the headlines: the allegedly money-hemorrhaging Fed. A recent Wall Street Journal op-ed revisited this subject last week, arguing the Fed is in the red and putting taxpayers on the hook. Assessing the 12 Federal Reserve district banks’ balance sheets, it posits 4 are insolvent and another 6 are headed that way, leaving the Fed with 2 (bad) options: Use taxpayer money to plug the holes (a weird bailout of sorts) or order banks to fork over capital to cover the district banks’ operating losses.^[i] A quiet bailout or increased liabilities for commercial banks doesn’t exactly sound like a winning menu of options. Yet it is also rather beside the point, in our view, considering this is a pure paper loss that doesn’t affect the Fed’s operations. We think this is a false fear—another brick in the young bull market’s wall of worry.

We covered the question of central bank insolvency last November and encourage you to give that a read if you would like more detail on why it is impossible for central banks to go bankrupt, but here is the Readers Digest version. The logic underpinning the insolvency claims seems simple: The Fed normally earns more interest on its Treasury holdings than it pays on bank reserves, handing the resulting profit over to the Treasury by rule. Now, however, it is paying more in interest on bank reserves than it is receiving as interest on its asset portfolio. Hence it is in the red. If the Fed were an actual bank, that could be bad. But the thing is, it isn’t. This red ink is a mere accounting entry. It just puts a dummy “deferred asset” on its balance sheet, which is basically an IOU from Future Fed. That is, once the Fed resumes earning positive net income, it won’t resume returning profits to the Fed until it has retained enough earnings to offset that prior loss. The Fed can still pay interest on reserves in the meantime by creating new money, but ensuring future income will cover present losses will keep this new money from ballooning money supply. In central bank jargon, this is called sterilizing money creation.

The Swiss and Czech central banks have managed just fine with chronic losses over the past several years. Both have implemented monetary policy with no operational hiccups, and we don’t recall reading about big central bank bailouts and policy emergencies. It was all just boring accounting and business as usual, much as the Fed is now. Any taxpayer money coming in will be replaced by future net income, making the notion of the Fed running up a big bar tab with Uncle Sam that it can’t pay without stressing commercial banks’ balance sheets rather far-fetched. Heck, maybe the actual lesson to defanging these fears would have been for Treasury to notch the massive profits the Fed paid in over the past 20 years as a dummy deferred liability. Not that it matters much, but it might preempt this discussion.

The notion of making commercial banks stanch the Fed’s alleged bleeding seems especially fanciful to us. It is true that commercial banks are shareholders in the Federal Reserve’s district banks and are responsible for covering capital to an extent—that is enshrined in the Federal Reserve Act. You may also remember that in March, when the Fed guaranteed Silicon Valley Bank’s uninsured deposits and concocted a new lending program to assist regional banks, it was funded in part by capital contributions from the largest banks, essentially deploying their robust balance sheets to backstop the system. But it seems like a leap to extrapolate this to a capital call to all commercial banks to cover operating-loss accounting entries. Ever since 2008, the Fed has been, well, obsessed with bank stability, as its latest efforts to shore up regional bank regulation can attest. It seems rather weird, to us, that it would order banks to essentially destabilize themselves in order to patch its balance sheet, then risk having to deploy that balance sheet to backstop them. That is just a really weird bank capital merry-go-round.

If recent history is a good guide, this topic will keep popping up intermittently for as long as Fed interest outlays exceed its interest income. When the Fed was increasing its balance sheet in the last decade, many feared eventual “losses.” They re-emerged last autumn, when the Fed first recorded a loss, then in the spring, and again now. But we think it looks mostly like much ado about paper losses and accounting entries, not anything that amounts to real-world losses for Americans or liabilities for commercial banks. That makes it the sort of revolving false fear typical of bull markets, much like US deficits, dollar swings and a host of others. Headlines will pounce, but stocks are adept at seeing through such things.