Said The Fed: "Damn The Accountants...Full Speed Ahead!"

 |  Includes: UDN, UDNT, UUP, UUPT
by: Charles A. Smith

Various news reports recently touted the fact that the U.S. Federal Reserve earned a profit of $77.4 billion in 2011 and returned the vast majority of it to taxpayers. And in fact the Fed's financial statements for 2011 show earnings from "seigniorage", which are net interest payments received by the Fed on currency issued, in the amount of $75.4 billion remitted to the Treasury. (The other $2 billion went back to member banks as dividends).

It sounds like a great deal for all of us, right? The Fed issues notes (currency) in return for safe and secure government bonds on which it earns interest, and then gives the difference between what it earns and what it pays on Federal Reserve Notes back to the taxpayer. What could go wrong?

Plenty, it turns out. But you'd never know it from the bare-bones disclosure within the Fed's financial statements. Unlike commercial banks, central banks have no line item on their balance sheets for "allowances for losses on loans and investments". There is literally no place for losses at a central bank.

So here's a quick thought experiment. What would happen if a central bank ventured away from the safe haven of Treasury bonds into the murky world of mortgage bonds as, say, part of an effort to support the housing market and the broader economy?

To date the U.S. Federal Reserve has purchased a total of $956 billion in agency debt and mortgage-backed securities. Given that one in four U.S. mortgages is currently underwater (the house is worth less than the debt), what are the odds that all of these mortgages will be paid in full, and are therefore worth the full amount the Fed paid for them?

How about zero? The Fed is sitting on some very large losses.

Do the financial statements inform us of this fact? Of course not. They give us not a clue that a decline in value is even possible. The only mention in the financial statements of the largest central bank on the planet that something could go wrong with their core strategy for supporting the economy reads as follows (from the footnotes to the balance sheet; emphasis mine):

"Accounting principles for entities with the unique powers and responsibilities of a nation's central bank have not been formulated by accounting standard-setting bodies. The Board of Governors has developed specialized accounting principles and practices that it considers to be appropriate for the nature and function of a central bank. These accounting principles and practices are documented in the Financial Accounting Manual for Federal Reserve Banks (NYSE:FAM)...and differences exist between the accounting principles and practices in the FAM and accounting principles generally accepted in the United States of America (GAAP), due to the unique nature of the Reserve Banks'powers and responsibilities as part of the nation's central bank and given the System's unique responsibility to conduct monetary policy.

The primary differences are the presentation of...securities holdings at amortized cost. Amortized cost, rather than the fair value presentation, more appropriately reflects the Reserve Banks' securities holdings given the System's unique responsibility to conduct monetary policy.

Although the application of fair value measurements to the securities holdings may result in values substantially greater or less than their carrying values, these unrealized changes in value have no direct effect on the quantity of reserves available to the banking system or on the prospects for future Bank earnings or capital.

Both the domestic and foreign components of the...portfolio may involve transactions that result in gains or losses when holdings are sold before maturity. Decisions regarding securities and foreign currency transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, fair values, earnings, and gains or losses resulting from the sale of such securities and currencies are incidental to open market operations and do not motivate decisions related to policy or open market activities."

So there you have it. As governors of the Federal Reserve system, we are not only not subject to generally accepted accounting principles, but the bonds we buy are worth exactly what we say they are, nothing more, nothing less. Humpty Dumpty couldn't have said it better! And the rationale for this bit of accounting intrangisence? Why, its our "unique responsibility to conduct monetary policy".

Instead of peering through the looking glass, let's say the Fed's $956 billion mortgage portfolio needed a 5% haircut to better reflect economic reality. Given that 2 of every 10 U.S. mortgages are in some form of distress, and might therefore deserve a 25% markdown, this seems reasonable (0.2 X 0.25 = 0.05). This amounts to a total writedown of $47.8 billion. The Fed has total equity of just under $54 billion. Thus a 5% hit to just the mortgage portion of the portfolio (the Fed owns other dodgy stuff as well) would leave them 90% of the way to insolvency!

That's certainly a long way from a tidy "profit" of $77 billion. But fear not: As the excerpted footnote implies, the Fed has no truck with concepts as menial as "insolvency" or "profit". Why should they, when they've got they're hands on a money machine capable of yanking the entire U.S. economy up by its shirtcollar?

Meanwhile the evidence that this is in fact the case is spotty at best. Nearly $3 trillion in Fed balance sheet expansion (i.e. money printing) has produced nothing more than a half-baked economic recovery (real GDP growth in this upcycle is literally one-half the post-war average), peppered by virulent bouts of inflation in gasoline and groceries. Sure, corporate earnings and stock prices have doubled from the bottom, but real wages, bank lending and small business and consumer sentiment remain mired at recession levels.

Over the past 4 years, we've been led to believe that the leadership at the Fed has a "multitude of tools" at their disposal. The blizzard of lending programs that grew out of the financial crisis (TALF, CPFF, MMIF, TSLF, PDCF, AMLF, etc.) certainly steered us that way. But from where I sit, Mr. Bernanke appears the proverbial man with only ONE tool: a printing press, and he seems willing to use it until he either reignites the economy or collapses the currency. Thus far we've seen a little of both, and nothing on the immediate horizon leads me to believe our halting recovery is going to change its stripes. The Fed turns 100 years young next year. Let us welcome this new era of prodigous credit creation with all the skepticism it deserves.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.