Surprised Again!: The COVID Crisis and the New Market Bubble Paperback

Published by Paul Dry Books.

by Alex J. Pollock and Howard B. Adler

Order here.

About every ten years, we are surprised by a financial crisis. In 2020, we were Surprised Again! by the financial panic of the spring triggered by the COVID-19 pandemic. Not one of the more than two dozen official systemic risk studies diligently developed in 2019 had even hinted at this financial crisis as a possibility, or at the frightening economic contraction which resulted from the political responses to control the virus. In response came the unprecedented government fiscal and monetary expansions and bailouts. Later 2020 brought a second big surprise: the appearance of an amazing boom in asset prices, including stocks, houses and cryptocurrencies.

Alex Pollock and Howard Adler lived through this historic instability while managing analytical support offices for the U.S. Financial Stability Oversight Committee. Their book lays out the many elements of the panic, the massive elastic currency operations which rode to the rescue, financing the bust with unprecedented government debt, the second surprise of the boom in asset prices, including a renewed apparent bubble in house prices financed by government guarantees, as well as considering key leveraged sectors such as commercial real estate, student loans, pension funds, banks, and the government itself. It reflects philosophically on how to understand these events in retrospect and prospect.

The Fed’s Tough Year

Published in Law & Liberty and republished in RealClear Markets.

The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:

• It has failed with inflation forecasting and performance;

• It has giant mark-to-market losses in its own investments and looming operating losses;

• It is under political pressure to do things it should not be doing and that should not be done at all.

Forecasting Inflation

As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.

The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25%, so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.

In short, the Federal Reserve cannot reliably forecast economic outcomes, or what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.

It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.

We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended “QE” strategy in 2012 as “a shot in the proverbial dark.” That was an honest admission, although unfortunately he admitted it only within the Fed, not to the public.

The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing.” Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.

Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.

Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.

A Mark-to-Market Insolvent Fed

Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of March 31, 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330 billion on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8 trillion of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200 billion in round numbers, bringing the Fed’s total MTM loss to over $500 billion.

Compare this $500 billion loss to the Fed’s total capital of $41 billion. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question—most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?

The Fed’s first defense of its huge MTM loss is that the loss is unrealized, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5 trillion of floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come, if the higher short-term interest rates implied by current market prices come to pass.

The Fed’s second defense is that it has changed its accounting so that realized losses on securities or operating losses will not affect its reported retained earnings or capital. Instead, the resulting debits will be hidden in a dubious “deferred asset” account. Just change the accounting! (This is exactly what the insolvent savings and loans did in the 1980s, with terrible consequences.)

What fun it is to imagine what any senior Federal Reserve examiner would tell a bank holding company whose MTM losses were 12 times its capital. And what any such examiner would say if the bank proposed to hide realized losses in a “deferred asset” account instead of reducing its capital!

Here is a shorthand way to think about the dynamics of how Fed operating losses would arise from their balance sheet: The Fed has about $8 trillion in long-term, fixed-rate assets. It has about $3 trillion in non-interest-bearing liabilities and capital. Thus, it has a net position of $5 trillion of fixed rate assets funded by floating rate liabilities. (In other words, inside the Fed is the financial equivalent of a giant 1980s savings and loan.)

Given this position, it is easy to see that pro forma, for each 1% rise in short-term interest rates, the Fed’s annual earnings will be reduced by about $50 billion. What short-term interest rate would it take to wipe out the Fed’s profits? The answer is 2.7%. If their deposits and repo borrowings cost 2.7%, the Fed’s profits and its contribution to the U.S. Treasury will be zero. If they cost more than 2.7%, as is called for in the Fed’s own projections, the Fed starts making operating losses.

How big might these losses be? In the Fed staff’s own recent projections, in its most likely case, the projected operating losses add up to $60 billion. This is 150% of the Fed’s total capital. In the pessimistic case, losses total $180 billion, over 4 times its capital, and the Fed makes no payments to the Treasury until 2030.

In such cases, should the Fed’s shareholders, who are the commercial banks, be treated like normal shareholders and have their dividends cut? Or might, as is clearly provided in the Federal Reserve Act, the shareholders be assessed for a share of the losses? These outcomes would certainly be embarrassing for the Fed and would be resisted.

The central bank of Switzerland, the Swiss National Bank (SNB), did pass on its dividends in 2013, after suffering losses. The SNB Chairman gave a speech at the time, saying in effect, “Sorry! But that’s the way it is.” Under its chartering act, the SNB—completely unlike the Fed—must mark its investment portfolio to market in its official profit and loss statement. Accordingly, in 2022 so far, the SNB has reported a net loss of $31 billion for the first quarter and a net loss of $91 billion for the first six months of this year.

The Swiss are a serious people, and also serious, it seems, when it comes to central bank accounting and dividends.

In the U.S., the Federal Reserve Bank of Atlanta did pass its dividend once, in 1915. As we learn from the Bank’s own history, “Like many a struggling business, it suspended its dividend that year.” Could it happen again? If the losses are big and continuing, should it?

A third Fed defense is that its “mandate is neither to make profits nor to avoid losses.” On the contrary, the Fed is clearly structured to make seigniorage profits for the government from its currency monopoly. While not intended by the Federal Reserve Act to be a profit maximizer, it was also not intended to run large losses or to run with negative capital. Should we worry about the Fed’s financial issues, or should we say, “Pay no attention to the negative capital behind the curtain!”

The Fed is obviously unable to guarantee financial stability. No one can do that. Moreover, by trying to promote stability, it can cause instability.

What the Fed Can and Can’t Do Well

The Federal Reserve is also suffering from a push from the current administration and the Democratic majority in the House of Representatives to take on a politicized agenda, which it probably can’t do well and more importantly, should not do at all.

This would include having the Fed practice racial preferences, that is, racial discrimination, and as the Wall Street Journal editors wrote, “Such racial favoritism almost certainly violates the Constitution. So does the [House] bill’s requirement that public companies disclose the racial, gender identity and sexual orientation of directors and executives.” The bill would “politicize monetary policy and financial regulation.” A lot of bad ideas.

Moreover, the Federal Reserve already has more mandates than it can accomplish, and its mandates should be reduced, not increased.

As has been so vividly demonstrated in 2021 and 2022, the Fed cannot accurately forecast economic outcomes, and cannot know what the results of its own actions, or its “shots in the proverbial dark,” will be.

Meanwhile, it is painfully failing to provide its statutory mandate of stable prices. Note that the statute directs the goal of “stable prices,” not the much more waffly term the Fed has adopted, “price stability.” It has defined for itself that “price stability” means perpetual inflation at 2% per year.

The Fed cannot “manage the economy.” No one can.

And the Fed is obviously unable to guarantee financial stability. No one can do that, either. Moreover, by trying to promote stability, it can cause instability, an ironic Minskian result—Hyman Minsky was the insightful theorist of financial fragility who inspired the slogan, “stability creates instability.”

There are two things the Fed demonstrably does very well.

The first is financing the government. Financing the government of which it is a part is the real first mandate of all central banks, especially, but not only, during wars, going back to the foundation of the Bank of England in 1694. As the history of the Atlanta Fed puts it so clearly:

During the war [World War I], the Fed was introduced to a role that would become familiar…as the captive finance company of a U.S. Treasury with huge financing needs and a compelling desire for low rates.

This statement is remarkably candid: “the captive finance company of [the] U.S. Treasury.” True historically, true now, and why central banks are so valuable to governments.

The second thing the Fed does well is emergency funding in a crisis by creating new money as needed. This was its original principal purpose as expressed by the Federal Reserve Act of 1913: “to furnish an elastic currency,” as they called it then. This it can do with great success in financial crises, as shown most recently in 2020, and of course during wars, although not without subsequent costs.

However, the Fed is less good at turning off the emergency actions when the crisis is over. Its most egregious blunder in this respect in recent years was its continuing to stoke runaway house price inflation by buying hundreds of billions of dollars of mortgage securities, continuing up to the first quarter of 2022. This has severe inflationary consequences as the cost of shelter drives up the CPI and erodes the purchasing power of households. Moreover, it now appears the piper of house price inflation is exacting its payment, as higher mortgage rates are resulting in falling sales and by some accounts, the beginning of a housing recession.

Among the notions for expanding the Fed’s mandates, the worst of all is to turn the Fed into a government lending bank, which would allocate credit and make loans to constituencies favored by various politicians. As William McChesney Martin, the Fed Chairman 1951-1970, so rightly said when this perpetual bad idea was pushed by politicians in his day, it would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

It is a natural and permanent temptation of politicians to want to do just that—to use the money printing power of the central bank to give money to their political supporters without the need for legislative approval or appropriation, and to surreptitiously finance it by imposing an inflation tax without legislation.

One way to achieve this worst outcome would be to have the Fed issue a “central bank digital currency” (CBDC) that allows everybody to have a deposit account with the Fed, which might then become a deposit monopolist as well as a currency monopolist.

Should that happen, the Fed would by definition have to have assets to employ its vastly expanded deposit liabilities. What assets would those be? Well, loans and securities. The Fed would become a government lending bank.

The global experience with such government banks is that they naturally lend based on politics, which is exactly what the politicians want, with an inevitable bad ending.

On top of that, with a CBDC in our times of Big Data, the Fed could and probably in time would choose to know everybody’s personal financial business. This could and perhaps would be used to create an oppressive “social credit system” on the model of China which could control credit allocation, loans, and payments. Given the urge to power of any government and of its bureaucratic agencies, that outcome is certainly not beyond imagining, and is, in my view, likely.

The current push to expand the Fed’s mandates is consistent with Shull’s Paradox, which states that the more blunders the Fed makes, the more powers and prestige it gets. But we should be reducing the Fed’s powers and mandates, not increasing them. Specifically:

• The Fed should not hold mortgage securities or mortgages of any kind. It should take its mortgage portfolio not just to a smaller size, but to zero. Zero was just where it was from 1914 to 2008 and where it should return.

• The Fed should not engage in subsidizing political constituencies and the proposed politicized agenda should be scrapped.

• Congress should definitively take away the Fed’s odd notion that the Fed can by itself, without Congressional approval, set a national inflation target and thereby commit the country and the world to perpetual inflation.

• Congress should repeat its instruction to the Fed to pursue stable prices. As Paul Volcker wrote in his autobiography, “In the United States, we have had decades of good growth without inflation,” and “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”

• The Fed should be required to have sound accounting for its own financial statements, with no hiding losses in the former savings and loan style allowed. This requires taking away from the Fed the power to set its own accounting standards, which nobody else has.

• The Fed should be prohibited from buying TIPS (Treasury Inflation-Protected Securities), because this allows it to manipulate apparent market inflation expectations.

• The funding of the Consumer Financial Protection Bureau expenses out of Fed profits should be terminated. This is an indefensible use of the Fed to take away the power of the purse from Congress and to subsidize a political constituency. It would be especially appropriate to end this payment if the Fed is making big losses.

• Finally, and most important of all, we must understand the inherent limitations of what the Federal Reserve can know and do. There is no mystique. We must expect it to make mistakes, and sometimes blunders, just like everybody else.

Knowing this, perhaps the 2020s will give us the opportunity to reverse Shull’s Paradox.

This paper is based on the author’s remarks at the American Enterprise Institute conference, “Is It Time to Rethink the Federal Reserve?” July 26, 2022.

Event Aug 24: Rethinking the Role of the Fed

Hosted by the Federalist Society:

Sponsors:

Pittsburgh Lawyers Chapter

Rivers Club
301 Grant St Suite 411
Pittsburgh, PA 15219

Register

Please join the Pittsburgh Lawyers Chapter for a luncheon event featuring Alex Pollock and Winthrop Watson.

Featuring:

• Alex Pollock, Senior Fellow, the Mises Institute

• Winthrop Watson, President/CEO, Federal Home Loan Bank Pittsburgh

More information here.

Letter: Money, machines and fundamental mistakes

Published in the Financial Times:

In his interesting letter (Letter, August 3), Konstantinos Gravas says that “money is a machine” and repeats the thought in several ways. To the contrary, money is not a machine. Financial markets are not machines. Economies are not machines. The mechanistic metaphor when applied to money, markets and economies is a source of fundamental mistakes.

All of these are complex, uncertain, recursive, reflexive, expectational, unpredictable, intertwined, interacting events, not machines. We don’t have a good name for these fascinating and often surprising worlds in which we live and interact.

FA Hayek in 1968 proposed the name “catallaxy,” to express that they are composed of ongoing exchanges, based on the Greek word “to exchange.” This did not catch on.

My suggestion is to name them “interactivities.” A key aspect of interactivities is that no one is outside them, looking down in divine fashion. Everyone, including central banks, regulators and experts of every kind, is inside the interactivity, subject to its fundamental uncertainty.

SHEFFIELD: Democrats’ Rosy Economic Picture Has Become A Nightmare As Recession Finally Hits

Published in the Daily Caller.

Under Powell’s watch, banks will win and everyday people lose, as AEI economists Paul H. Kupiec and Alex J. Pollock report: “For the first time in its 108-year history, the Federal Reserve System faces massive and growing mark-to-market losses and is projected to post large operating losses in the near future … Because they are now paid interest on their reserve balances and receive guaranteed dividends on their Federal Reserve stock, member banks will monetarily benefit from the Fed’s policy to fight inflation while the public bears Federal Reserve system losses. Meanwhile, the public at large will also face the costs of higher interest rates, reduced growth and employment and losses in their investment and retirement account balances.”

Mises Institute's Alex Pollock explains why economics is not a science

On Chicago’s Morning Answer radio. Listen here.

The Fed Cannot Go Bankrupt; However, It Can Bankrupt the Country

Published by the Mises Institute.

07/13/2022 Patrick Barron

A recent essay on the Mises Wire triggered quite a bit of discussion among a group of Austrian school economists. Paul H. Kupiec and Alex J. Pollock's "Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?" became the focal point for a wide-ranging discussion of monetary issues that got to the heart of our monetary and overall economic future.

The Fed Cannot Go Bankrupt

The article itself is a fairly straightforward explanation of how the Fed works, and provides several options that the Fed might pursue in a rising interest rate environment. The authors contend that the Fed has intervened itself into a corner, where losses probably will increase as the Fed raises rates. David Howden opined that this might not happen, as the Fed will roll over its mostly short-term, low-yielding investments into higher-earning assets, which will tend to protect its net interest income and provide an operating profit. Furthermore, the Fed is not required to mark its low-yielding investments to market. Were it required to do so, the Fed's true financial weakness would be revealed.

The Fed Ignores the Rule of Law

But what can or will be done about it? Early in their essay, Kupiec and Pollock conclude that nothing will be done, despite the provisions of the law that created the Fed over one hundred years ago. The losses will not go away; they simply will be transferred to the unwitting public through loss of purchasing power. Per Kupiec and Pollock:

"Innovations" in accounting policies adopted by the Federal Reserve Board in 2011 suggest that the Board intends to ignore the law and monetize Federal Reserve losses, thereby transferring them indirectly through inflation to anyone holding Federal Reserve notes, dollar denominated cash balances and fixed-rate assets.

The "innovation" in accounting policies centers around the Fed's newly minted "deferred asset" account, to which underwater assets will be transferred. Per Kupiec and Pollock:

Today, the Federal Reserve Board's official position is that, should it face operating losses, it would not reduce its book capital surplus, but instead would just create the money needed to meet operating expenses and offset the newly printed money by creating an imaginary "deferred asset" (Section 11.96) on its balance sheet.

If the Fed were subject to the rule of law, either it would have stopped money printing years ago or its creditors would have forced it to close its doors. Yet the rule of law is completely ignored. Per Kupiec and Pollock:

The Federal Reserve Board's proposed treatment of system operating losses is wildly inconsistent with the treatment prescribed by the Federal Reserve Act.

The Keynesians running our economic life may be reassured that the Fed cannot fail in a technical sense, but the public should be appalled. The continual monetization of the federal budget threatens the complete loss of the dollar's purchasing power—to wit, a Weimar Republic–style catastrophe.

Unlawful Monetary Debasement Causes Capital Destruction

Today's monetary leaders fail to understand the true nature of money and, therefore, cannot conceive that there are real consequences to their outlandish irresponsibility in monetizing government debt and brazenly dismissing the rule of law. As the facilitator of monetary debasement, borne by the general public, the Fed fosters the destruction of societal capital.

The federal government does not have to answer to the law nor the public for its irresponsible and destructive spending. The purpose of insolvency is to force an institution, whether public or private, to stop destroying capital. Austrian school economists understand that capital must be created by hard work, innovation, frugality, and, most of all, savings. The market allocates scarce capital to those enterprises that create things worth more than those scarce inputs.

The Solution Is a "Return to Sound Money"

In 1953 Ludwig von Mises added a relatively short final chapter to his 1913 masterpiece The Theory of Money and Credit. Chapter 3 of part 4 is titled "The Return to Sound Money." It is as relevant today as it was almost seventy years ago. Mises explains how the US in particular could anchor the dollar to its gold reserves. The Fed would be eliminated and replaced by little more than a board that would monitor all dollars to make sure they are backed 100 percent by gold.

Mises was a master in presenting what self-serving Keynesian scholars try to hide in a fog of deception; i.e., that money can and should be subject to the rule of law, as are all other economic goods in society. I daresay that there is no single reform that comes closer to fostering peace, freedom, and prosperity than a "return to sound money."

Biden’s Pension Bailout Is a Giveaway to Unions

Most plans were insolvent long before the pandemic.

Published in The Wall Street Journal.

By Howard B. Adler and Alex J. Pollock

President Biden boasted last week about his administration’s bailout of union multiemployer pension plans, enacted in the American Rescue Plan supposedly to address pandemic-related problems. “Millions of workers will have the dignified retirement they earned and they deserve,” he said July 6 in Cleveland. In fact, the American taxpayer will bear the cost of union plans that were insolvent long before the pandemic. The bailout all but guarantees future insolvency or another bailout and constitutes a massive giveaway to labor unions.

Multiemployer pension plans are a creation of unions. They are defined-benefit retirement plans, maintained under collective-bargaining agreements, in which more than one employer contributes to the plan. These plans are typically found in industries such as trucking, transportation and mining, in which union members do work for multiple companies.

As of 2019, there were 2,450 multiemployer plans with 15 million participants and beneficiaries. Many were insolvent well before the Covid pandemic. The Pension Benefit Guaranty Corp. estimated total unfunded liabilities of PBGC-guaranteed multiemployer plans at $757 billion for 2018. According to 2019 projections, 124 multiemployer pension plans declared that they would likely run out of money over the next 20 years.

Read the rest here.

AEI Event July 26: Is It Time to Rethink the Federal Reserve?

Via the American Enterprise Institute.

The Federal Reserve is having a bad year. As the Fed struggles to control inflation, it is also being asked to expand its policy remit to include climate change. Moreover, the House of Representatives just passed a bill requiring the Fed to adopt new policy goals of equal employment and wealth outcomes for targeted interest groups beyond its existing goals of price stability and full employment. How will these efforts to “rethink the Fed” affect monetary policy, credit availability, and economic growth?

Join AEI as a panel of experts discusses monetary policy, the Fed’s dual role as central banker and regulator, its independence, and recent congressional and executive branch efforts to further expand its legislative mandates.

Agenda

10:00 a.m.
Introduction:
Paul H. Kupiec, Senior Fellow, AEI

10:15 a.m.
Panel Discussion
Panelists:
Gerald P. Dwyer, BB&T Scholar, Clemson University
Alex J. Pollock, Senior Fellow, Mises Institute
George Selgin, Senior Fellow, Cato Institute

Moderator:
Paul Kupiec, Senior Fellow, AEI

11:40 a.m.
Q&A

12:00 p.m.
Adjournment

Contact Information

Event: Bea Lee | Beatrice.Lee@aei.org
Media: MediaServices@aei.org | 202.862.5829

Related

Who Owns Federal Reserve Losses, and How Will They Affect Monetary Policy?
Paul H. Kupiec and Alex J. Pollock | AEI Economic Policy Working Paper Series | June 17, 2022

The Fed Is Raising Interest Rates to Make Up for Its Own Inaction
George Selgin | Cato Institute | June 15, 2022

Government Debt and Inflation: Reality Intrudes
Gerald P. Dwyer | American Institute for Economic Research | March 22, 2022

The Federal Reserve Keeps Buying Mortgages
Alex J. Pollock | Mises Institute | January 8, 2022

The government triangle at the heart of U.S. housing finance

Published by Housing Finance International.

The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system.

In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. “The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,” with “endless pleadings of self-interest.”

Such pleadings have characterized the U.S. housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt. That’s $8 trillion. This sum is about 70% of the $11 trillion of mortgages in the country. Does it make sense for the U.S. government to guarantee 70% of the whole market? It does not. But so it has evolved in the politics of U.S. housing.

As part of this evolution, U.S. mortgage finance has become dominated by a tightly linked government triangle. The first leg of the triangle is composed of Fannie, Freddie and Ginnie (with its associated Federal Housing Administration). This leg we may call the Government Housing Complex.

The second leg in the government mortgage triangle is the United States Treasury. The Treasury is fully liable for all the obligations of the 100% government-owned Ginnie. The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too. Through clever financial lawyering, it is not a legal guarantee, however, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total U.S. government debt. Unsurprisingly, this is not politically desired.

The same politically undesired, but honest, accounting result would follow if, on top of owning 100% of Fannie and Freddie’s $270 billion of senior preferred stock, the Treasury controlled 80% of their common stock. Government accounting rules require that at 80% the entity's debt must be consolidated into the government debt. That is why Treasury controls 79.9%, not 80%, of their common stock, which is done through warrants with an exercise price that rounds to zero. This is historically consistent, since to get Fannie’s debt off the government’s books was the main reason for its 1968 restructuring it into a so-called “government-sponsored enterprise,” so that President Lyndon Johnson’s federal deficit did not look as big.

The Federal Reserve didn’t used to be, but it has become the third leg of the government mortgage triangle, as the single biggest funder of mortgages by far. Its $2.7 trillion of mortgage securities holdings are limited to those guaranteed by Fannie, Freddie and Ginnie. But those guarantees are only credible because they are in turn backed by the credit of the Treasury.

However, there is another curious circle here. How can the Treasury, which runs huge continuing deficits and runs up its debt year after year, be thought such a good credit? It turns out that an essential support of the credit of the Treasury is the readiness of the Federal Reserve always to buy government debt by printing up the money to do so. This is why having a fiat currency central bank of its own is so very useful to any government. The intertwined credit of the Treasury and of the Federal Reserve are intriguingly dependent on each other, and they both support the credit of the government mortgage complex of Fannie, Freddie and Ginnie.

In this sense, it is helpful to think of the Federal Reserve and the Treasury as one thing – one combined government financing operation, whose financial statements should be consolidated. In such consolidated statements, the $5.8 trillion of Treasury debt owned by the Federal Reserve would be a consolidating elimination. With this approach, we could see the reality more clearly. The Federal Reserve buys and monetizes Treasury debt. Consolidate the statements. The Treasury bonds disappear. What is really happening? The consolidated government prints up money and spends it. In order to spend, it is taxing by monetary inflation, without the need to vote on taxes and without the need for the legislature to act at all.

We should then bring Fannie, Freddie and Ginnie into the consolidation. The government mortgage complex issues mortgage securities, then the Federal Reserve buys and monetizes them. Consolidate the statements, and the mortgage securities held by the Federal Reserve also disappear as a consolidating elimination. What reality is left? The consolidated government prints up “free” money and uses it to make mortgage loans, inflating the price of houses. This arrangement suits housing lobbyists, to be sure, and the proponents of “modern monetary theory” who wish to have no limits on the government’s ability to spend. Of course, this theory is an illusion. The reality, and the most fundamental of all economic principles is: Nothing is free. Free printed money becomes very expensive indeed when it turns into destructive inflation.

In principle, a fiat currency central bank can buy and monetize not just bonds and mortgages, but any asset. For example, the Swiss National Bank (the central bank) includes a large portfolio of U.S. stocks in its investments. It recently reported a net loss of $33 billion for the first quarter of 2022, caused by its $37 billion in investment losses. In the U.S. case, the Federal Reserve in the Covid financial crisis, in cooperation with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent state of Illinois as investments for the central bank.

Further back in history, in the 1960s, some members of the U.S. Congress thought, with the encouragement of the savings & loan industry, that the Federal Reserve ought to buy bonds to provide money to housing. Federal Reserve Chairman William McChesney Martin resisted, arguing that this would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That was the right answer, consistent with Economics in One Lesson. But it did not please the politicians. Senator William Proxmire pointedly threatened the Fed:

“You recognize, I take it” he said to the Fed Vice Chairman in 1968, “that the Federal Reserve Board is a creature of the Congress? [That] the Congress can create it, abolish it, and so forth?... What would Congress have to do to indicate that it wishes…greater support to the housing market?”

A new Federal Reserve Chairman, Arthur Burns, arrived in 1971, and decided it would be a good idea to “demonstrate a cooperative attitude.” So, the Federal Reserve began to buy the bonds (not mortgages) of federal housing and other government agencies. It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks of Cooperatives, and – believe it or not – the debt of the Washington DC subway system. There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.

The Federal Reserve fortunately managed to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s. Will it be able to get out of its vastly bigger mortgage program now?

In 1978, Hazlitt wrote in The Inflation Crisis, And How to Resolve It: “Inflation, not only in the United States but throughout the world, has… not only continued, but spread and accelerated. The problems it presents, in a score of aspects, have become increasingly grave and urgent.”

In 2022, with U.S. inflation is running at over 8%, here we are again.

As the Federal Reserve now moves to address the inflation, interest rates on the standard American 30-year fixed rate mortgage have gone from their suppressed level of 3% in 2021 to about 5½% in May 2022. Although historically speaking, that is still rather low, it will make many houses unaffordable for those who need a mortgage loan to buy. The interest expense for the same-sized mortgage for the same-priced house has increased by about 80%. How much higher might mortgage interest rates go? With higher mortgage rates, how quickly will the runaway house price inflation end? Will that be followed by a fall in U.S. house prices from their current bubble heights? We are waiting to see.

Letter: Raising a family is economically productive

Published in the Financial Times.

On page 1 of your June 20 edition is a graph which shows women who are “looking after family” as “economically inactive”. What nonsense.

Keeping a household going, raising children and caring for family members is a most productive economic activity — far more productive than, say, marketing cryptocurrencies.

Your mistaken graph is part of the same confusion that thinks cooking in a restaurant is production, but cooking at home isn’t; that working in a day care centre is production, but bringing up your own children isn’t; that growing food to sell is production, but growing your own food isn’t; that painting a room for money is production, but painting your own room isn’t. It’s a pretty silly conceptual mistake. The Financial Times apparently has forgotten that the root meaning of “economics” in Greek is “management of a household.”

Alex J Pollock

Senior Fellow, Mises Institute

Lake Forest, IL, US

Also cited in a following letter:

Letter: At last some recognition for the housewife

In response to the letter by Alex J Pollock (“Raising a family is economically productive”, June 27) I say “hear, hear” and “thank you”!

At last, women who’ve been or are full-time housewives for years are being given recognition as being valuable contributors to the economics of everyday life.

It seems we have saved the “breadwinners” a fortune by rearing the children, doing the cooking, the gardening, painting, walking the dogs, doing the laundry and being a chauffeur.

We also have the time to help with non-profit-making activities in the community. I remember a quote from the late Anita Roddick: “If a woman can run a home, she can run a business”.

It’s a good life too; we are our own bosses, every day is different and it’s up to us to use our free time well.

Sarah Tilson

Kilternan, Ireland

Who owns the Fed’s massive losses?

Published in The Hill and RealClear Markets.

By Paul H. Kupiec and Alex J. Pollock

We estimate that at the end of May, the Federal Reserve had an unrecognized mark-to-market loss of about $540 billion on its $8.8 trillion portfolio of Treasury bonds and mortgage securities. This loss, which will only get larger as interest rates increase, is more than 13 times the Federal Reserve System’s consolidated capital of $41 billion.

Unlike regulated financial institutions, no matter how big the losses it may face, the Federal Reserve will not fail. It can continue to print money even if it is deeply insolvent. But, according to the Federal Reserve Act, Fed losses should impact its shareholders, who are the commercial bank members of the 12 district Federal Reserve banks.

Among Federal Reserve officials and many economists, it is fashionable to argue that any losses the Federal Reserve should suffer, no matter how large, will have no operational consequence. Now that the Fed has already experienced mark-to-market losses of epic proportions and will soon face large operating losses, something it has never seen in its 108-year history, we are about to see if this is true.

Member banks must purchase shares issued by their Federal Reserve district bank. Member banks only pay for half the par value of their required share purchases “while the remaining half of the subscription is subject to call by the Board.”

In addition to potential calls to buy more Federal Reserve bank stock, under the Federal Reserve Act member banks are also required to contribute funds to cover any district reserve bank’s annual operating losses in an amount not to exceed twice the par value of their district bank stock subscription. Note especially the use of the term “shall” and not “may” in the Federal Reserve Act:

“The  shareholders  of every  Federal  reserve  bank shall  be  held  individually responsible,  equally  and  ratably,  and  not  one  for  another,  for  all  contracts, debts,  and  engagements  of  such  bank  to  the  extent  of  the  amount subscriptions  to  such  stock  at  the  par  value  thereof  in  addition  to  the  amount subscribed.” (bold italics added).

Despite congressional revisions to the Federal Reserve Act over more than a century, the current Act still contains this exact passage.

By the Federal Open Market Committee’s own estimates, short-term policy rates will approach 3.5 percent by year-end 2022. Many think policy rates will go higher, maybe much higher, before the Fed successfully contains surging inflation. Our estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent. This estimate assumes the Fed has no realized losses from selling securities. If short-term rates reach 4 percent, we estimate an annualized operating loss of $62 billion, or a loss of 150 percent of the Fed’s total capital.

This unenviable financial situation — huge mark-to-market investment losses and looming negative operating income — is the predictable consequence of the balance sheet the Fed has created. The Fed is paying rising rates of interest on bank reserves and reverse repurchase transactions while its balance sheet is stuffed with low-yielding long-term fixed rate securities. In short, the Fed’s income dynamics resemble those of a typical 1980s savings and loan.

In 2011, the Federal Reserve announced its official position regarding realized losses on its investment portfolio and system operating losses:

“In the unlikely scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.”

Under this unique accounting policy, operating losses do not reduce the Federal Reserve’s reported capital and surplus. A positive reserve bank surplus account is ensured by increasing an imaginary “deferred asset” account district reserve banks will book to offset an operating loss, no matter how large the loss. Among other things, this accounting “innovation” ensures that the Fed can keep paying dividends on its stock. Similar creative “regulatory accounting” has not been utilized since the 1980s when it was used to prop up failing savings institutions.

The Fed’s stated intention is to monetize operating losses and back any newly created currency with an imaginary “deferred asset.” It is impossible to imagine that the authors of the Federal Reserve Act would have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks dividends and interest on their reserve balances, when the act itself makes member banks as stockholders liable for Federal Reserve district bank operating losses.

Clearly, if the Fed is required to comply with the language in the Federal Reserve Act and assess member banks for its operating losses it could impact monetary policy. The prospect of passing Fed operating losses on to member banks could create pressure to avoid losses by limiting the interest rate paid to member banks or discouraging asset sales needed to shrink the Fed’s bloated balance sheet. Moreover, if the Fed’s losses were passed on, some member banks may face potential capital issues themselves.  

Will the Fed ignore the law, monetize its losses, and create a new source of inflationary pressure? Or will it pass its losses on to its shareholders? Stay tuned.

Who Owns Federal Reserve Losses and How Will They Impact Monetary Policy?

Published by the American Enterprise Institute.

By Paul H. Kupiec and Alex J. Pollock

Abstract

For the first time in its 108-year history, the Federal Reserve System faces massive and growing mark-to-market losses and is projected to post large operating losses in the near future. In a 2011 policy statement, the Federal Reserve Board outlined its plan to monetize system operating losses notwithstanding the (apparently) little-known fact that the Federal Reserve Act requires Federal Reserve member banks (the stockholders who own the Federal Reserve district banks) to share at least a portion of district reserve bank operating losses. Contrary to opinions expressed by Federal Reserve system officials, should the Fed abide by the legal requirements in the current version of the Federal Reserve Act, operating losses could impact monetary policy. If the Fed chooses to ignore the law and monetize operating losses, member banks will be in the enviable (if difficult to justify) position of directly benefiting from the current inflation. Because they are now paid interest on their reserve balances and receive guaranteed dividends on their Federal Reserve stock, member banks will monetarily benefit from the Fed’s policy to fight inflation while the public bears Federal Reserve system losses. Meanwhile, the public at large will also face the costs of higher interest rates, reduced growth and employment and losses in their investment and retirement account balances. Should the public recognize the implications of the Fed’s plan to monetize its operating losses, the Fed could face an embarrassing “communication problem”.

Read the full PDF here.

Post page here.

Biden’s Appointments Speak to an Extremist Agenda

Published in TownHall.

Perhaps the most outrageous example of the president’s extremist appointments was his nomination of Saule Omarova to head the Office of the Comptroller of the Currency. A graduate of Moscow State University on the Lenin Personal Academic Scholarship, Omarova tweeted in 2019, “Until I came to the US, I couldn’t imagine that things like gender pay gap still existed in today’s world. Say what you will about old USSR, there was no gender pay gap there. Market doesn’t always 'know best.'” In an academic paper Omarova’s advocated that “central bank accounts fully replace — rather than compete with — private bank accounts.” It’s disturbing that a person who spent much of her academic career deriding capitalist institutions and advocating for unprecedented government management of the economy, was nominated for such a critical economic position. At least the nation can be thankful that Omarova withdrew her nomination in December – as many moderate Democrats made clear they could not support her nomination.

Read the rest here.

The INDEX Act Is a Major Step Forward In Corporate Governance

Published in RealClear Markets. Also published in the Federalist Society.

An unsolved problem in American corporate governance is that a few big asset management firms have through their index funds grabbed dominating voting power in hundreds of corporations by voting shares which represent not a penny of their own money at risk. They have in effect said to the real investors whose own money is at risk, “I’ll just vote your shares.  I’ll vote them according to my agenda.  I don’t want to bother with what you think.”

This obviously opens the door for the exercise of hubris, as has perhaps notably been the case with BlackRock, but more importantly, it violates the essential principle that the principals, not the agents, should govern corporations. This principle is well-established and unquestioned when it comes to broker-dealers voting shares held in street name. The brokers can vote on significant matters only with instructions from the economic owners of the shares. Exactly the same clear logic and rule should apply to the managers of the passive funds which have grown so influential using other people’s money.

Now Senators Pat Toomey (R-PA), the Ranking Member of the Senate Banking Committee, and Dan Sullivan (R-Alaska), with eleven co-sponsors, have addressed the problem directly by introducing an excellent bill: The INDEX (Investor Democracy Is Expected) Act. This bill would apply the longstanding logic for broker-dealer voting to passive fund asset manager voting, which makes perfect sense. As Senator Toomey said in announcing the bill, “The INDEX Act returns voting power to the real shareholders…diminishing the consolidation of corporate voting power.” You couldn’t have a goal more basic than that.

This bill ought to be approved by overwhelming bipartisan majorities. To oppose it, any legislator would have to sign up to the following pledge: “I believe Wall Street titans should be able to vote other people’s shares without getting instructions from the real owners.” That does not sound like a political winner.

The asset management firms themselves seem to be feeling the force of the INDEX Act logic. BlackRock said it looks forward “to working with members of Congress and others on ways to help every investor—including individual investors—participate in proxy voting.” Vanguard said it “believes it is important to give investors more of a voice in how their proxies are voted.”

If enacted, as it should be, the INDEX Act will require these nice words to be put into action.

Western Economic Association International: 97th Annual Conference

Conference information here.

June 29-July 3, 2022, in Portland, Oregon

Panel: Stablecoin That Might Work

Date: 6/30/2022
Time: 2:30 PM to 4:15 PM

Organizer

Walker F. Todd, Middle Tennessee State University

Chair

Walker F. Todd, Middle Tennessee State University

Papers

The Chicago Plan and CBDCs (Virtual)

• Presenter(s): Ronnie Phillips

Proposal for a U.S. National Stablecoin System (In Person)

• Presenter(s): Franklin Noll, Noll Historical Consulting, LLC

Which was the Better Design: National Banks of the 19th Century or Stablecoins of the 21st? (Virtual)

• Presenter(s): Alex J. Pollock, Ludwig von Mises Institute

Replacing the Dollar with the SDR in International Reserves (In Person)

• Presenter(s): Warren Coats, International Monetary Fund

Event: Central Bank Digital Currency--Efficient Innovation or the End of the Private Banking System?

Hosted by the Federalist Society.

Central Bank Digital Currencies (CBDC) are the subject of a global debate.  In one version, individuals and businesses would hold deposits directly with the central bank.  Critics point out that the Federal Reserve would then control how these deposits are used, allocating credit to private-sector borrowers and to government spending, arguing that CBDCs would eviscerate the private banking industry and create government surveillance of all financial transactions in the accounts. An alternate version is that CBDCs take the form of a tokenized dollars, distributed through the banking system and operating in parallel with paper currency and bank accounts.  Supporters say this could yield lower transaction costs and more rapid settlement of payments, and could strengthen the international role of the U.S. dollar.

Featuring:

Bert Ely, Principal, Ely & Company, Inc.

Chris Giancarlo, Senior Counsel, Willkie Digital Works LLP; Former Chairman, US Commodity Futures Trading Commission

Greg Baer, President & Chief Executive Officer, Bank Policy Institute

Moderator: Alex J. Pollock, Senior Fellow, the Mises Institute

Letter: Central banker chattiness is a flawed PR strategy

Published in the Financial Times.

Gary Silverman observes that “US central bankers . . . have become relentlessly chatty, appearing on stage and screen” in contrast to “opaqueness in the old days” (“The Fed transforms into reality TV show”, On Wall Street, FT Weekend, April 9).

The former opacity had a huge advantage for central bankers: it hid the fact that they did not know what was going to happen or what they would be doing about it.

Transparency has a corresponding big disadvantage. It makes obvious to all that they have no more knowledge of the future than anybody else.

They cannot escape this problem because the financial and economic future always displays what economists call the “Knightian uncertainty” after Frank Knight’s book Risk, Uncertainty and Profit (1921) and his theory that the future is not only unknown but unknowable.

Given this fact, the Federal Reserve and all central bankers have a public relations problem. Opacity looks like a superior strategy to chattiness.

Why You Can Bet on Another Bubble Popping

Published by Gold Newsletter.

Why do bubbles still prevail in an era of ubiquitous information? Alex J. Pollock, a senior fellow with the Mises Institute, makes the case that fundamental uncertainty in finance and economics is unavoidable.

Recommended Links

• Visit Alex’s website.

• Purchase his books:

  • Finance and Philosophy: Why We’re Always Surprised.

  • Boom and Bust: Financial Cycles and Human Prosperity.

• “What Intellectuals Resent about Laissez Faire,” by Fergus Hodgson.

• “Why Financial Genius Will Fail Again,” by Fergus Hodgson.

• Purchase the book: Manias, Panics, and Crashes: A History of Financial Crises.

Can the Federal Reserve Stop Being the World’s Biggest Savings & Loan?

Published in Housing Finance International Journal. Also published in HCWE.

The Federal Reserve’s huge monetization of residential real estate mortgages is one of the radical developments in the history of American housing finance, central banking, money creation, and credit inflation.

Through this investment, the Federal Reserve has become a new element in the massive interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt, which represents about 70% of the country’s total mortgage loans. In addition, we now find that mortgage funding, cheap mortgage interest rates, and inflated house prices have become dependent on the Federal Reserve. Getting mortgages on the central bank’s balance sheet was a fateful step.

To summarize the story: Into the American financial system strode the Federal Reserve, its pockets filled with newly printed dollars and its printer handy to create more. It bought up the biggest pile of mortgage assets than anybody ever owned. It bought even more Treasury securities, too, accumulating $5.8 trillion of them, so that its balance sheet has reached the memorable total of $8.9 trillion. This is a development not imagined by anyone beforehand, including the Fed itself.

As of March 2022, the Fed owns $2.7 trillion of mortgage securities – in other words, about 23% of all the mortgages in the country are on the central bank’s balance sheet. Moreover, mortgages have become 30% of the Fed’s own inflated total assets. These are truly remarkable numbers, which would certainly have astonished the founders of the Federal Reserve System. I enjoy imagining the architects of the Fed in financial Valhalla, in a lively but puzzled discussion of how their creation of 1913 turned into a giant mortgage funder. Nothing could have been further from their intentions.

Since March 2021, one year ago, the Fed has added $557 billion to its mortgage portfolio, increasing the balance by $46 billion a month on average. It had to buy a lot more than that in order first to replace the repayments and prepayments of the underlying mortgages and then increase the outstanding holdings. The Fed has been the reliable Big Bid in the market, buying mortgages with one hand and printing money to make the purchases with the other.

During this time, the giant U.S. housing sector, representing about $38 trillion in current market value of houses, has experienced an amazing price inflation. U.S. house prices shot up 17% in 2021, as measured by the median sales price, and by 18.8%, as measured by the Case-Shiller national house price index. In January 2022, average house prices rose at the rate of 17%. House prices are far over the 2006 peak which was reached during the infamous Housing Bubble (which was followed by six years of falling prices).

Faced with the rapid escalation in house prices, the Fed unbelievably kept on stimulating the housing market by buying ever more mortgage securities. It thus further inflated the asset price bubble, subsidizing mortgages and distorting house and land prices.

By acquiring $2.7 trillion in mortgages on its balance sheet, the Federal Reserve has made itself far and away the biggest savings & loan institution in the world. Like the savings & loans of old, the Fed owns very long-term fixed-rate assets, and it neither marks its investments to market in its financial statements nor hedges it’s extremely large interest rate risk.

Like the saving & loans of the 1970s, it has loaded up on 15 and 30-year fixed rate mortgages, just in time to experience a period of threateningly high inflation.

Will the Federal Reserve withdraw from being a giant savings & loan? On March 16, 2022, the Fed announced that it “expects to begin reducing its holdings of Treasury securities and agency debt securities and mortgage-backed securities.” This move is very late. The specific decision may be made, the Fed said, “at a coming meeting.” For now, it will keep buying to replace the runoff of the current portfolio. However, shrinkage of the investments in the future seems intended and may be “faster than last time.” How far will such shrinkage, especially of the massive mortgage portfolio, go?

The Fed’s $2.7 trillion in mortgage securities is double the level of March 2020, but more to the point, infinitely greater than the zero of 2006.

From 1913 to 2006, the amount of mortgages the Federal Reserve owned was always zero. That defined “normal.” What is normal now? Should the Fed’s mortgage portfolio be permanent or temporary? Can the mortgage market now even imagine a Fed which owns zero mortgages? Can the Fed itself imagine that?

Should the Federal Reserve’s mortgage portfolio not just shrink some, but go back to zero?

In my opinion, it should indeed go back to zero.

In the beginning of its mortgage buying, this was clearly the Federal Reserve’s intent. As Chairman Bernanke testified to Congress about this bond and mortgage buying program (or “QE”) in 2011:

“What we are doing here is a temporary measure which will be reversed so that at the end of the process the money supply will be normalized, the amount of the Fed’s balance sheet will be normalized, and there will be no permanent increase, either in the money outstanding, or in the Fed’s balance sheet.”

Obviously, that was bad forecast, but that does not mean the intentions were not sincere at the time. “I genuinely believed that it was a temporary program and that our balance sheet would go back [to normal]” said Elizabeth Duke, a Fed Governor from 2008 to 2013.

The recent book, Lords of Easy Money, relates that:

“As far back as 2010, the Fed was debating how to normalize. Credible arguments were made that the process would be completed by 2015, meaning that the Fed would have sold off the assets it purchased through quantitative easing.”

A formal presentation to the Federal Open Market Committee in 2012 projected that the Fed’s investments “would expand quickly during 2013 and then level off at around $3.5 trillion after the Fed was done buying bonds. After that, the balance sheet would start to shrink, gradually, as the Fed sold off all the assets it bought, falling to under $2 trillion by 2019.” Obviously, that didn’t happen.

Early on, the Fed realized that if it did sell assets, and interest rates had normalized to higher levels, and the prices of bonds and mortgages had therefore fallen, it could be realizing significant losses on its sales. Of course, the Fed has made no sales as yet.

The yield of the 10-year U.S. Treasury note touched 2.38% on March 22 as I write, and the 30-year fixed rate mortgage rate reached 4.62%. These rates are high compared to recent experience, but they are still very low, historically speaking, especially compared to the current inflation. Historically, more typical rates would be 4% or more for the 10-year Treasury, and 5% to 6% for mortgages, or more. The interest rate on 30-year mortgage loans was never less than 5% from the mid1960s to 2008.

If the Fed stops suppressing mortgage interest rates and stops being the Big Bid for mortgages, how much higher could those interest rates go from their present, still historically very low level? When the mortgage interest rates rise, how quickly will the runaway house price inflation end?

This leads to an interesting question about the Fed itself: As interest rates rise, how big will the losses on the Fed’s vast mortgage portfolio, and on its even vaster portfolio of long-term Treasury bonds, be? Could the losses be big enough to make the Fed insolvent on a mark-to-market basis?

The duration of the Fed’s $2.7 trillion mortgage portfolio is estimated at about 5 years. That means that for each 1% that mortgage interest rates rise, the portfolio loses 5% of its market value. So a 1% rise would be a loss in market value of about $135 billion, and a 2% rise in mortgage rates, a loss of value of $270 billion.

With the $5.8 trillion of Treasury securities on the Fed’s balance sheet, it owns about 24% of all Treasury debt in the hands of the public and a lot of very long bonds. I tried to estimate the duration of the portfolio and came up with about 5 years. Then on a 1% increase in rates, the market value loss to the Fed will be $285 billion and on a 2% rise, $570 billion.

Add the mortgage results and the Treasury portfolio results together and you get these market value losses in round numbers: for a 1% rise in rates, over $400 billion; for a 2% rise, over $800 billion.

Now compare that to the net worth of the consolidated Federal Reserve System, which is $41 billion. A capital of $41 billion is subject to a potential market value loss of $400 billion or $800 billion. It is easy to imagine that the Fed may become insolvent on a mark-to-market basis, just as the savings & loans were in the 1980s.

But does mark to market insolvency matter if you are a fiat currency central bank? Most economists say No. If the Fed were mark-to-market insolvent, probably nothing would actually happen. You would still keep accepting its notes in payments. The Fed would keep accounting for its securities at par value plus unamortized premium, and the unrealized loss, however massive, would not touch the balance sheet or the capital account.

But suppose the Fed actually does sell mortgages and bonds into a rising rate market, and takes realized, cash losses. Suppose they bought a mortgage security for the price of 103, and sell it for 98, for a realized loss of 5, and that 5 is gone forever. Wouldn’t that loss have to hit the capital account, and if such losses were big enough, force the Fed’s balance sheet to report a negative capital – that is, technical insolvency?

It may surprise you to learn, as it surprised me to learn, that the answer is that this realized, cash loss would not affect the Fed’s reported capital at all. No matter how big the realized losses were, the Fed’s reported capital would be exactly the same as before. That ought to be impossible, so how is it possible?

It is because in 2011, while considering how it might one day sell the mortgages and bonds it was accumulating, the Fed logically realized that if interest rates returned to more normal levels, it would be selling at a loss. What to do? It decided to change its accounting. The Federal Reserve has the advantage of setting its own accounting standards. It decided to account for any realized losses on the sale of securities not as a reduction in retained earnings and capital but as an intangible asset! This was clever, perhaps, but hardly upright accounting. I would certainly hate to be the CFO of an SEC-regulated corporation who tried that one.

But here is a great irony: This is precisely what the old savings & loans, facing insolvency, did in the early 1980s. So the new, biggest savings and loan in the world, potentially faced with the same problem as the old ones, came up with the same idea.

Will the Federal Reserve really get out of its “temporary” mortgage program now? Will it ever get back to the formerly normal zero? And if it ever sells mortgage securities, what losses will it realize?