There’s been much debate about the possibility of the US central bank going broke.
Forget it. But not because of the Federal Reserve’s fiscal position, per se.
Earlier this month the central bank made a subtle change to its accounting methods. One that might make it impossible for the Fed to show capital losses.
The timing of the move was probably not coincidental, either.
The central bank announced the change just as the debate about its solvency, ability and credibility was really heating up. Especially the idea that the Fed might be unable to tighten policy as much as required when the economy recovers, since doing so could lead it to go bankrupt and then the US Treasury would have to step-in and recapitalise, thus potentially undermining the central bank’s independence.
Anyway, here’s the accounting change:
Effective January 1, 2011, as a result of the accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U.S. Treasury. Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U.S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board’s H.4.1 statistical release. The liability for the distribution of residual earnings to the U.S. Treasury will be reported as “Interest on Federal Reserve notes due to U.S. Treasury” on table 10. Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the U.S. Treasury were included in “Other capital accounts” in table 9 and in “Other capital” in table 10.
Some explaining is needed, and we’re indebted to Bank of America Merrill Lynch’s US rates team — Ralph Axel, Priya Misra and Brian Smedley — for their help with this.
An accounting explainer
Since 1947, the Fed has been required to send, or remit, most of its profits to the US Treasury, as opposed to using them to build up its own capital. These remittances are roughly equal to income from the Fed’s loans and securities holdings minus operating expenses and stuff like interest paid on reserves, dividends paid to member banks and — ahem — any amount needed to top-up the Fed’s own capital (paid-in capital).
These remittance payments have surged in recent years — along with the Fed’s unconventional policy measures and balance sheet. Indeed, that puffed-up balance sheet is the thing causing people to worry about potential losses to the central bank, especially if short-term interest rates were to rise enough so that interest paid on bank reserves exceeded the Fed’s interest income from its Soma portfolio (where it keeps the US Treasuries and Mortgage-Backed Securities bought as part of its unconventional policy measures). Or, more basically, the Fed could incur losses if it just started selling securities below their original purchase price.
Before the above accounting change, any unremitted earnings that were due from the Fed to the US Treasury would accrue in that ‘other capital’ account. Now however, they’ll be shown in a separate liability item called ‘interest on Federal Reserve notes due to US Treasury.’ So instead of any future Fed losses showing up as a reduction in Fed capital (‘other capital’) — they’ll now show up as negative interest due to the US Treasury. The Fed will still send most of its profits to the Treasury on a weekly basis, but will postpone remittances if the new line item becomes negative.
In short — Fed losses will now be offset against future Fed remittances to the Treasury. And the US central bank seems to have made it impossible for it to ever record a negative capital position, at least on paper. It’s a rather clever, if devious, solution to the Fed’s inability to use its own earnings to build up capital against future losses.
Why do we care?
Well — the change means we can forget the Fed ever having the kind of accounting loss that would force it to go cap-in-hand to the US Treasury for a capital top-up — thereby averting the independence problem. (It’s worth noting too, that the European Central Bank has already had to do this via its national central banks).
But then, it doesn’t really matter whether or not the Fed does go bankrupt or not. We’re talking a central bank with a well-lubricated printing press, after all, and that hefty (if controversial) backing from the US Treasury.
But there is always that lingering credibility issue…
The below from Bank of America Merrill Lynch’s Ralph Axel:
Following on the heels of the US$600bn extension to its quantitative easing program, these kind of moves do not promote confidence in the Fed, but rather cause concern within the markets. We will not make too much of a fuss over this accounting change, but the overall theme of reduced government credibility is strengthened by it.
In our view, the ongoing decline in credibility ultimately translates into a higher chance of a downgrade in the sovereign credit rating. Although we are not looking for a downgrade to US government credit in our base-case scenario, we think markets are likely to become more and more nervous about the outlook, and rates, particularly at the longer maturities, could adjust accordingly. Rating agencies have been more outspoken recently about their concerns over US credibility, pointing out that unless the country takes significant near-term steps to reverse the upward trajectory of debt ratios, a triple-A rating may no longer be appropriate. We believe the latest developments on both the debt ceiling and the Fed’s accounting changes present a further challenge to government credibility, which in turn could contribute to underperformance of the long end of the Treasury curve.
State of the junk – Alex Dalmady
Beyond QE – to central bank credibility – FT Alphaville
Is negative convexity the new Bernanke condundrum? – FT Alphaville