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Federal Reserve Game

The Federal Reserve reported profits of $52.1 billion in 2009  They will turn over $46.1 billion to the U.S. Treasury.  When Wall Street was losing their shirt, the Fed was raking in the profits.  On the surface, there is some outrage that the Fed was making money during the credit crisis.
How can there beat outrage, it is impossible to understand.  How can you report a profit, when you created money out of thin air and called it "quantitative easing?"  There is no credit entry for the money they created, they do not owe it to anyone.  You couldn't get away with this playing Monopoly.
Remember, the Fed ‘printed’ money by making a computer entry.  This was called “quantitative easing.”  They used this ‘new’ money to buy Treasury bonds and Mortgage Backed Securities (MBS).  This pumped money into the economy and created demand for bonds at lower interest rates.  Lower interest rates let banks make money on the credit spread and worked to push air back into the real estate bubble.
Now the Fed has a problem.  They booked a profit, and who couldn’t make money if you can print money to buy bonds that pay interest?  However, they have over a trillion dollars in securities that pay very low rates.  Some say the Fed may have up to $2 trillion in bonds.  That is not a problem if they hold them to maturity, but stated policy of the Fed is to remove the extra money from the money supply as the economy recovers.  This is to slow inflation, and stop the economy from overheating.  To remove the liquidity, they must sell the bonds and ‘destroy’ the money paid to them.
Interest rates are expected to rise in 2010.  An old bond that pays 2% must be sold at a discount to similar bonds yielding 3%  The old bond is sold for less than the discount on the new bond so the yield on the old bond is 3%.  This means the Fed will have to write down the value of their bonds as interest rates rise.  This is also called “mark to market.”
Treasury bonds are sold at a discount to the face value.  The purchaser pays a price less than face value; this discount represents the return or imputed interest rate the bond returns.
If the blended return on one trillion dollars in bonds is 2% with maturity of five years, and interest rates moved higher to affect a rate of 3% on similar bonds, what would the original bonds be worth?  Here are the numbers:
Five years Interest on one trillion at:
Blended Face value:                       1,000,000,000,000.00
                   at 2%
$20,000,000,000.00 x 5 years =      100,000,000,000.00
Simple discounted price:                    $900 billion
Blended Face value:                       1,000,000,000,000.00
                 at 3%
$30,000,000,000.00 x 5 years =       150,000,000,000.00
Simple discounted price:                     $850 billion
The older bonds would have to be sold at $850 billion, with the seller booking a $50 billion loss. The discount difference is larger than in this simple example, in that the interest is calculated over a five year period. The discount difference also becomes larger on longer term bonds.
Conclusion: The Fed cannot work out of their long position in bonds without losses. As they withdraw from suppressing interest rates, their portfolio will be written down with larger discounts. Of course, they can keep some of the “quantitative easing” money on their books to avoid liquidity problems. The Treasury announcement to make unlimited funds available to Fannie Mae and Freddie Mac seems all the more sinister. You can read about Who Determines Interest Rates from December 30. When we peel back this skin on the onion, who is rescuing who?



Disclosure: No Positions