I know it sounds crazy to suggest that the Federal Reserve Bank is in trouble, but it's true. When interest rates rise, the Fed is going to recognize huge losses and will need help from the U.S. Treasury to stay afloat.
I have been writing about the Fed's financial predicament for almost two years (Who's Gonna Bail Out The Fed, May 2011 and The Fed's Big Secret - Quantitative Easing Isn't Free, January 2013), but now I am no longer alone in voicing alarm. Four Nobel Prize hopeful economists have confirmed that the Fed is in trouble.
On February 22, 2013, Frederic Mishkin, Peter Hooper, James Hamilton and David Greenlaw published Crunch Time: Fiscal Crises and the Role of Monetary Policy, an 86-page paper that predicts the Fed will stare down the barrel of a few hundred billion dollars of losses when interest rates rise.
Mishkin and his team forecast that rising interest rates will cause losses at the Fed which may in turn tip the U.S. into an unsustainable deficit spending path. The paper ominously states that the Fed's worst nightmare may happen when "Fed policy decisions [come] under greater public scrutiny, potentially leading to controversy that could even threaten central bank independence."
Unfortunately, Mishkin's team is engaging in wishful thinking because the problem is a lot worse than they think; Fed losses are larger, more certain and a lot nearer in time than they understand. And it's a sure bet that Fed decision making will be second guessed through an intense, detailed and hostile Congressional investigation.
The Fed's troubles started when it decided to purchase trillions of dollars of long-term fixed rate assets and exclusively financed these purchases with short-term floating rate borrowed money. When interest rates rise, as sooner or later they will, the market value of the Fed's assets will plunge and the Fed will become insolvent. It will have market value losses in the hundreds of billions of dollars, if not greater than $1 trillion. Also, the Fed will experience future continuing operating losses as it adjusts its balance sheet, which will make it a drain on the U.S. Treasury for years to come.
The Fed decided to double down on its bet that the laws of finance don't apply when it dramatically increased the size of its balance sheet without increasing its equity. The Fed has borrowed an aggregate of $3.24 trillion, and has only has $55 billion of equity to back up its obligations. And every year it makes its problems worse by paying out all of its net income as dividends to its shareholder, the U.S. Treasury. As a result, for all practical purposes, the Fed has no equity, no reserves and only a razor thin margin for error. With leverage of approximately 59-to-1, the Fed's balance sheet is more overleveraged than Lehman Brothers, Bear Stearns, CIT, FreddieMac or FannieMae before they failed.
The Mishkin team states:
The magnitude of the Fed's cumulative net income losses could…even [approach] several times the size of Fed capital…This unfavorable fiscal arithmetic might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed's holdings of longer-term government securities…the problems facing the U.S. in the next decade could easily escalate into an unmanageable situation.
When the Fed's problems become recognized by non-economists, it will become public enemy #1 as both liberal and conservative politicians wake up to the fact that quantitative easing wasn't free. Talking heads will accuse the Fed of overstepping its mandate, and Fed independence will be booty to be snatched from the ground like candy fallen from a smashed piñata.
However, it doesn't have to be that way. The future hasn't happened yet and the Fed can still save itself.
First, the Fed could stop pretending that quantitative easing is free. It should immediately suspend paying dividends, set up balance sheet reserves and retain its capital to cover future losses from changes in interest rates. Had the Fed done that when it started quantitative easing, they would already be holding about $250 billion of such reserves and by the time interest rates rise, the Fed would have had as more than $500 billion of reserves, or 10 times its current retained capital.
Second, the Fed can change the terms and nature of its asset purchases. The Fed has multiple paths to achieve its policy aims while protecting its balance sheet; none of which it is using. Fed policy makers need to use their detailed understanding of micro economics and bank finance to creatively implement policy adjustments.
Mishkin's opinions matter. He is a former Fed Governor and one of the most influential economists in the world. Unfortunately, his work tells us that economists in and out of the Fed didn't realize when they saved the economy through quantitative easing that they were digging their own grave and haven't figured out how to put away their shovels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.