A Frightening Solution to the Debt Ceiling Crunch

Published in Law & Liberty by Alex J. Pollock and Paul H. Kupiec.

Could the debt ceiling crunch be avoided by the Federal Reserve forgiving treasury debt? Let's hope not.

Much has been written about the Congressional debt-ceiling standoff. US Treasury and Federal Reserve Board officials have insisted that the only way to prevent a federal government default on its debt is for Congress to simply raise the debt ceiling without requiring any reduction in spending and deficits.

However, more imaginative measures could be taken to forestall a general federal government default without increasing the debt ceiling. For example, we have previously shown that legislation that increases the statutory price of the US Treasury’s gold holdings from its absurdly low price of $42.22 per ounce to something close to gold’s $2000 per ounce market value provides an efficient process—one historically used by the Eisenhower administration—to significantly increase the Treasury’s cash balances and avoid default while budgetary debate continues.

In this note, we explore, as a thought experiment, the possibility that the cancellation of up to $2.6 trillion of the $5.3 trillion in Treasury debt owned by the Federal Reserve System could be used to avert a federal government default without any increase in the debt ceiling. We suggest that, given the enforcement of current law, federal budget rules, and Federal Reserve practices, such an extraordinary measure not only would be permissible, but it could be used to entirely circumvent the Congressional debt ceiling.

The Federal Reserve System owns $5.3 trillion in US Treasury securities, or about 17% of the $31 trillion of Treasury debt outstanding. The Fed uses about $2.7 trillion of these securities in its reverse repurchase agreement operations, leaving the Fed with about $2.6 trillion of unencumbered US Treasury securities in its portfolio.

What would happen if the Fed “voluntarily” released the Treasury from its payment obligations on some of all of the unencumbered US Treasury securities held in the Fed’s portfolio, by forgiving the debt? We believe there is nothing in Constitution or the Federal Reserve Act that would prohibit the Fed from taking such an action. This would free up trillions in new deficit financing capacity for the US Treasury without creating any operating difficulties for the Federal Reserve.

There is a longstanding debate among legal scholars as to whether the Fourteenth Amendment to the Constitution makes it unconstitutional for the federal government to default on its debt. But voluntary debt forgiveness by the creditor on the securities owned by the Federal Reserve would not constitute a default and the arguments related to the Fourteenth Amendment would not be applicable.

The Federal Reserve System is an integral part of the federal government, which makes such debt forgiveness a transaction internal to the consolidated government. However, the stock of the twelve Federal Reserve district banks is owned by their member commercial banks. Would it create losses for the Fed’s stockholders if the Fed absolved the US Treasury of its responsibility to make all payments on the US Treasury securities held by the Fed? We don’t think so.

The Fed has already ignored explicit passages of the Federal Reserve Act that require member banks to share in the losses incurred by their district Federal Reserve banks. Under its current operating policies, the Fed would continue to pay member banks dividends and interest on member bank reserve balances even if the entire $2.6 trillion in unencumbered Treasury debt securities owned by the Federal Reserve System were written off. Such a write-off would make the true capital of the Federal Reserve System negative $2.6 trillion instead of the negative $8 billion it is as of April 20.

The Federal Reserve Act requires member banks to subscribe to shares in their Federal Reserve district bank, but member banks need only buy half the shares they have pledged to purchase. The Federal Reserve Act stipulates that the “remaining half of the subscription shall be subject to call by the Board.” At that point, the member banks would have to buy the other half. Presumably, the Fed’s founders believed that such a call would be forthcoming if a Federal Reserve Bank suffered large losses which eroded its capital.

In addition, Section 2 of the Act [12 USC 502] requires that member banks be assessed for district bank losses up to twice the par value of their Federal Reserve district bank stock subscription.

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, whether such subscriptions have been paid up in whole or in part under the provisions of this Act. (bold italics added)

To summarize, Fed member banks are theoretically required to buy more stock in a losing Federal Reserve district bank and to be assessed to offset some of the Reserve Bank’s losses. However, these provisions of the Federal Reserve Act have never been exercised and are certainly not being exercised today, in spite of the fact that the Fed’s accumulated losses are now greater than its capital. Indeed, the Fed consistently asserts that it is no problem for it to run with negative capital however large that capital shortfall may become.

Historically, all Fed member banks were entitled to receive a 6 percent cumulative dividend on the par value of their paid-in shares. Subsequently, Congress reduced the dividend rate for large banks to the lesser of “the high yield of the 10-year Treasury note auctioned at the last auction” (currently 3.46%), but maintained the 6% for all others. The Fed is now posting large operating losses but is still paying dividends to all the member banks. We confidently predict it will continue to do so.

Unlike normal shareholders, member banks are not entitled to receive any of their Federal Reserve district bank’s profits beyond their statutory dividend payment. The legal requirements and Federal Reserve Board policies governing the distribution of any Federal Reserve System earnings in excess of its dividend and operating costs have changed many times since 1913, but today, the Fed is required by law to remit basically all positive operating earnings after dividends to the US Treasury—but now there aren’t any operating earnings to remit.

Beginning in mid-September 2022, the Federal Reserve started posting cash losses. Through April 20, 2023, the Fed has accumulated an unprecedented $50 billion in operating losses. In the first 3 months of 2023, the Fed’s monthly cash losses averaged $8.7 billion. Notwithstanding these losses, the Fed continues to operate as though it has positive operating earnings with two important differences—it borrows to cover its operating costs, and it has stopped making any remittances to the US Treasury.

The Fed funds its operating loss cash shortfall by: (1) printing paper Federal Reserve Notes; or (2) by borrowing reserves from banks and other financial institutions through its deposits and reverse repurchase program. The Fed’s ability to print paper currency to cover its losses is limited by the public’s demand for Federal Reserve Notes. The Fed borrows most of the funds it needs by paying an interest rate 4.90 percent on deposit balances and 4.80 percent on the balances borrowed using reverse repurchase agreements. These rates far exceed the yield on the Fed’s investments.

In spite of its losses, the Fed continues to pay member banks both dividends on their shares and interest on their reserve deposits. The Fed has not exercised its power to call the second half of member banks’ stock subscriptions nor has it required member banks to share in the Fed’s operating losses.

Instead of assessing its member banks to raise new capital, the Fed uses nonstandard, “creative” accounting to obscure the fact that it’s accumulating operating losses that have rendered it technically insolvent.

Under current Fed accounting policies, its operating losses accumulate in a so-called “deferred asset” account on its balance sheet, instead of being shown as what they really are: negative retained earnings that reduce dollar-for-dollar the Fed’s capital. The Fed books its losses as an intangible “asset” and continues to show it has $42 billion in capital. While this treatment of Federal Reserve System losses is clearly inconsistent with generally accepted accounting standards, and seemingly inconsistent with the Federal Reserve Act’s treatment of Federal Reserve losses, Congress has done nothing to stop the Fed from utilizing these accounting hijinks, which the Fed could also use to cancel the Treasury’s debt.

Under these Fed operating policies, if all of the unencumbered Treasury securities owned by the Fed were forgiven and written off, the Fed would immediately lose $2.6 trillion. It would add that amount to its “deferred asset” account. Because the Fed would no longer receive interest on $2.6 trillion in Treasury securities, its monthly operating losses would balloon from $8.7 billion to about $13 billion, for an annual loss of about $156 billion. Those losses would also go to the “deferred asset” account. Treasury debt forgiveness would delay by decades the date on which the Fed would resume making any remittances to the US Treasury, but by creating $2.6 trillion in de facto negative capital, the Fed would allow the Treasury to issue $2.6 trillion in new debt securities to keep on funding federal budget deficits.

Under the federal budgetary accounting rules, the Fed’s deferred asset account balances and its operating losses do not count as expenditures in federal budget deficit calculations, nor do the Fed’s borrowings to fund its operations count against the Congressionally imposed debt ceiling. So in short, the Fed offers a way to evade the debt ceiling.

In reality, of course, the debt of the consolidated government would not be reduced by the Fed’s forgiveness of Treasury debt. This is because the $2.6 trillion the Fed borrowed (in the form of bank reserves and reverse repurchase agreement loans) to buy the Treasury securities it forgives would continue to be liabilities of the Federal Reserve System it must pay. The Fed would have $2.6 trillion more liabilities than tangible assets, and these Fed liabilities are real debt of the consolidated federal government. But in accounting, the Fed’s liabilities are uncounted on the Treasury’s books. Under current rules, there appears to be no limit to the possibility of using the Fed to expand government debt past the debt ceiling.

In other words, the Fed’s write-off of Treasury securities and its ongoing losses could accumulate into a massive amount of uncounted federal government debt to finance deficit spending. A potential loophole of trillions of dollars around the Congressional debt limit is an astonishing thought, even by the standards of our current federal government. Let’s hope Congress closes this potentially massive budgetary loophole while the idea of the Fed’s forgiving Treasury debt remains just a thought experiment.

Alex J. Pollock is a Senior Fellow at the Mises Institute and was the principal deputy director of the office of financial research of the U.S. Treasury Department, 2019-21. He is author of Finance and Philosophy—Why We’re Always Surprised and co-author of Surprised Again!—The COVID Crisis and the New Market Bubble.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute, where he studies systemic risk and the management and regulations of banks and financial markets. Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC) and director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

PG-15: FEDSOC STUDY BREAK: Cryptocurrency From All Angles

Watch the video here.

The Federalist Society’s Financial Services & E-Commerce Practice Group, Student Division & University of Pennsylvania Carey Law School Chapter

PRESENT

Cryptocurrency From All Angles

Featuring

Alex J. Pollock

Senior Fellow, Mises Institute;

Executive Committee Member,

Financial Services & E-Commerce Practice Group

Tuesday, April 18, 2023

Breaktime: 8:00 P.M. - 8:30 P.M. ET

How High Interest Rates Turn ‘Paper Losses’ Into Real Ones

If you borrowed money to invest in bonds, waiting for them to mature will cost a bundle.

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to a sharp rise in interest rates since March 2022, the financial system is facing eye-popping mark-to-market losses on its fixed-rate assets. These include more than $1 trillion of market-value losses on the Federal Reserve’s portfolio of bonds and mortgage securities—and according to some estimates, a $2 trillion market-value loss on the fixed-rate securities and loans of the banking system.

Central-bank officials suggest that we needn’t worry, because these unrealized “paper” losses won’t translate to cash losses if the underwater investments are held to maturity. Though the market price is down today, the thinking goes, an institution will receive 100 cents on the dollar if it holds its security to maturity and thus won’t incur a loss.

The argument is appealing yet superficial. The notion that these are “simply paper losses” doesn’t hold up in the real banking world, where investments are financed with short-term borrowing. Even when underwater investments are held to maturity, a mark-to-market loss is a forecast of future high cash interest costs on the funds borrowed to finance the investment.

Suppose that in 2021, when the Fed had kept short-term interest rates near zero, you borrowed money to buy a seven-year $10,000 U.S. Treasury note yielding 2%. In 2023, when the note had five years remaining, the central bank raises the interest rate to 5%. The market price of your note drops from $10,000 to about $8,700, for an unrealized loss of $1,300 and a 13% decline in market value. This is about the same as the year-end mark-to-market discount the Fed has disclosed on its long-term investments.

Like the Fed, you may believe this $1,300 unrealized loss is merely a paper loss since the note will be held to maturity, when it will pay $10,000. But that neglects that you, like the Fed, funded the note with short-term borrowing that must be continually renewed at a cost of 5%.

If interest rates stay at 5% for the next five years, you will receive a 2% yield—or $200 a year in interest—but will pay 5%, or $500 a year, in interest on your debt. Holding the note costs 3% of $10,000, or $300 a year. Over the next five years, the total cash loss to carry this note to maturity will be $1,500, or a loss of 15% of your original investment, even though you never sold your Treasury note and it matured at par. This is a net cash loss with the cash gone forever.

This example is no doubt simplified by assuming a flat yield curve and ignoring fluctuating interest rates. But it nevertheless correctly demonstrates the economics of large mark-to-market losses on leveraged fixed-rate assets held by the Fed and many banks. The soaring costs of financing underwater held-to-maturity investments will generate large operating losses on these investments. If short-term interest rates continue to rise, the loss will be larger. Lower rates would stem the bleeding, but as long as they exceed 2%, holding the note in our example will generate a cash operating loss.

For the Fed and commercial banks, there are some funding sources that impose no or minimal interest costs. The central bank can issue paper currency that bears no interest but in amounts limited by the public’s demand for paper money. Banks can fund some of their investments with transaction deposits, which pay little or no interest to the account holder but impose deposit insurance and other operating costs on the bank. In both cases, though, these funding sources reduce the cost of carrying an underwater asset.

Now, let’s apply this analysis to the Fed’s investments in Treasury and mortgage securities, which totaled about $8.4 trillion as of year-end 2022. These investments have an average yield of about 2%. About $7.2 trillion have a remaining maturity of more than one year, $4 trillion of which have remaining maturities of over 10 years. These long-term securities account for most of the Fed’s reported $1 trillion in mark-to-market losses.

On the liability side, the Fed has about $2.3 trillion in outstanding currency—i.e., dollar bills—that can be used to fund part of the $7.2 trillion in long-maturity assets. The remaining $4.9 trillion are financed with floating rate deposits and reverse-repurchase-agreement borrowings on which the Fed now pays about a 4.9% interest rate.

The zero-interest-bearing paper currency that funds the $2.3 trillion of these 2% fixed-rate assets generates about $46 billion in annual net interest income for the Fed. The remaining $4.9 trillion in assets also yield 2%, but this income is more than offset by the 4.9% cost of financing these assets and, on balance, cost the Fed $142 billion. Combined, its fixed-rate held-to-maturity investments cost the central bank $96 billion annually. Adding its $9 billion in noninterest expenses, the Fed can expect an annual operating loss of about $105 billion.

A $105 billion annual loss equates to an average monthly loss of $8.7 billion. This estimate mirrors reality. The Fed’s actual net loss year-to-date through March 30 has averaged $8.7 billion per month.

If any institution, including the central bank, borrows short-term to finance long-term fixed-rate investments, large mark-to-market losses aren’t merely “paper” losses. They’re a forecast that holding investments to maturity is going to be extremely expensive.

Could the Treasury selectively default on the Fed’s debt?

Published in The Hill with Paul H. Kupiec.

A reporter from this publication recently asked how a debt ceiling standoff might impact the banking system. One obvious answer is that if the Treasury ran out of cash and defaulted on the payments owed on its debt securities, the banking system would suffer since it collectively owns, per our calculations, about $1.3 trillion in Treasury securities that have always been treated as “risk-free.”

U.S. Treasury securities do not have cross-default clauses, so the Treasury could choose to default on only a specific set of selected securities sparing banks and others. This gives rise to a provocative question:

Could the U.S. Treasury save cash by selectively defaulting just on securities owned by the Federal Reserve System? How would this impact the Fed? How much cash would be freed up to pay other Treasury bills?

The Federal Reserve owns about $5.3 trillion in U.S. Treasury securities. The Fed’s 2022 audited financial statements show that $721 billion of these securities mature between April 1 and Dec. 31 and that the Fed received almost $116 billion in interest payments from the Treasury last year, or about $9.6 billion a month. Between now and Dec. 31, the Fed is scheduled to receive about $800 billion in interest and maturing principal payments from the Treasury, cash Treasury could use to pay its other bills if it stopped paying the Fed.

How would the Fed cope with a selective Treasury default? The same way it is managing what we’ve calculated is an ongoing $8.6 billion in operating losses per month — by borrowing the additional money it needs to operate and thus creating more debt for the consolidated government and ultimately a taxpayer liability.

If the Treasury suspended all payments due on its securities held by the Federal Reserve System, presumably by agreement with the Federal Reserve, the Fed would be short the cash it previously received. It would increase its borrowing to fund its operations, but the impact on the Fed’s reported operating loss would depend on the details of the suspension agreement and the accounting treatment adopted by the Fed.

Once Congress lifts the debt ceiling, we presume that the Treasury would pay the Fed its balances in arrears. Would the Treasury also pay accrued interest on the suspended amounts it owes the Fed? If so, at what rate?

The suspension of interest payments would clearly reduce the Fed’s cash interest received but it would not immediately increase the reported Federal Reserve operating losses. The Fed would likely account for suspended interest payments as non-cash interest income earned and create a new asset category, “interest income receivable from Treasury,” on its balance sheet.

The non-payment of interest would increase, dollar-for-dollar, the amount the Fed needs to borrow to pay its bills. Going forward, the Fed would have to continue borrowing to fund suspended Treasury balances. If these balances accrued interest at the Fed’s borrowing cost, there would be no future impact on the Fed’s reported operating income. If the Treasury agreed to a lower interest accrual rate or no interest accrual, the Fed’s reported operating losses would increase.

If the suspended maturing principal payments are merely delayed until Congress increases the debt ceiling, the Fed would likely record these as deferred balances due from the U.S. Treasury and would not create a reserve for a credit loss. The suspension would disrupt the Fed’s quantitative tightening plans as its Treasury security balances would not run off as planned.

With the suspension of interest payments on the Fed’s portfolio of U.S. Treasury securities, the Fed would increase its borrowing to cover not only its ongoing operating losses, now about $8.6 billion per month, but also the additional cash shortfall created by the suspension, about $9.6 billion a month, for a total new borrowing of $18.2 billion a month.

The Fed would fund its cash shortfall by (1) printing paper Federal Reserve Notes or (2) borrowing reserves from banks and other financial institutions through its reverse repurchase program. Because the Fed’s ability to fund its losses by printing paper currency is limited by the public’s demand for Federal Reserve Notes, the Fed will have to borrow most of the funds paying an interest rate of 4.90 percent on borrowed reserve balances and 4.80 percent on the balances borrowed using reverse repurchase agreements.

Loans to the Federal Reserve System, whether from reserve balances or repurchase agreements, are backed by Treasury securities owned by the Fed, or by the full faith credit of the U.S. federal government, since the Fed is the fiscal agent of the U.S. Treasury. However, unlike securities issued by the Treasury, when the Federal Reserve borrows, its loans are not counted in the federal government debt that is limited by the statutory debt ceiling. Indeed, Federal Reserve system cash operating losses are not counted as expenditures in federal budget calculations. Because of these budgetary loopholes, Fed operating losses are excluded from any federal budget deficit cap and its borrowings circumvent the statutory federal debt ceiling.

Could the U.S. Treasury take the extraordinary step of selectively halting interest and principal payments on the Treasury securities owned by the Federal Reserve System? We do not recommend such an action but see nothing in law or current Federal Reserve accounting and operating practices that would preclude it should the Treasury need to take emergency measures to avoid a wider federal government default.

If extraordinary measures are needed, a better alternative is free up funds by updating the Congressionally legislated price of the Treasury’s 8,000 tons of gold to ensure prompt payments on all the Treasury’s debt and maintain the credit performance of the United States government.

The Bill Walton Show: "Are We Really Surprised We're Having Another Banking Crisis?" with Alex Pollock and Steve Dewey

Published by Bill Walton.

It looks like the bill is finally coming due after decades of reckless monetary policy and out of control federal spending. After 40 years of relatively stable prices, we now have raging inflation. Interest rates have risen dramatically. Mortgage rates have more than doubled. And commercial banks are now sitting on more than $600 billion of unrealized bond losses. 

Of course, and as expected, with the Silicon Valley Bank bailout, the Regulators have pulled out their default playbook declaring yet another institution systematically risky, taking another step toward the federalization of our banking system.

But there's also something new to worry about: regulatory mission drift. The Fed's historical mandates are to 1) promote price stability and 2) full employment and a safe and sound banking system. But instead, the Fed - and the Treasury - have changed their priorities to promote the progressive policies of climate change and equity. 

Joining me to talk all this through are Alex Pollock and Steve Dewey. Both are grizzled veterans of the banking and regulatory world, which, as Alex points out, has been hit by a major crisis every decade since the 1970s. Together we have many decades of experience in financial markets. Alex and I have been conversing with each other, and interrupting each other, for almost fifty years.  

Alex is a Senior Fellow at the Mises Institute and was Principal Deputy Director of the Office of Financial Research of the U.S. Treasury Department in 2019 and through 2021. He was also my second boss in the commercial banking world almost 45 years ago and was on my board at Allied Capital Corporation as we worked through the 2008 crisis and its aftermath. 

Steve Dewey worked for several years in Asia during the Asian financial crisis and for the FDIC during and after the 2008 financial crisis where he was involved in the resolution of failed banks. 

According to Alex,

“We are still living in the aftermath of the long manipulation of interest rates and financial markets by the Federal Reserve and the club of central banks worldwide: the vast expansion of money and suppression of interest rates to an abnormally low level. Now we’re seeing the results.” 

Meantime, rather than being the above-the-fray dispassionate wise actor, the Federal Reserve has become part of the problem:  Just in the last six months, the Fed itself lost $44 billion which exceeds its capital of $42 billion. A big portion of its $8.7 trillion in assets are highly vulnerable to rising interest rates. Ironically, the Fed’s interest rate risk is similar to SVB’s. 

So, what’s going to happen next?

The Fed and the Treasury seem likely to take more control in the name of risk management. The banking system holds $17 trillion of deposits and Treasury Secretary Janet Yellen recently declared that these would be de facto insured by the Treasury, the Fed and the FDIC. 

But consider this: the FDIC’s deposit insurance fund is $128 billion, which is - putting it mildly - a little short of $17 trillion. Also, if the Fed continues losing money on its mortgage-backed securities, it will be losing over $100 billion a year.  

Republican Senator Everett Dirksen, the Minority leader during the 1960s Kennedy-Johnson years, once said “a billion here, a billion there, and pretty soon we’re talking real money.” Now we’re talking trillions. Has the banking system become to big to save?

Will the “solution” be a nationalized bank and a digital currency to prevent a collapse of the system? Or something else? How do the woke climate and equity agendas figure into this? 

There’s a lot to speculate about here. Join in our conversation for our take on the crisis. 

As always, we try to make complicated things easier to understand and nothing right now seems more complicated than our money.

The Fed’s Capital Goes Negative

Published by the Mises Institute.

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion—just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level. The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen—about how a billion here and a billion there starts to add up to real money—we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative? I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie.

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages. The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses. Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent. Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent.

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury. So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans. Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.

All banks together have tangible capital of about $1.8 trillion. So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

The Fed’s Capital Goes Negative

Published in NY Sun.

The Fed’s Capital Goes Negative

The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion — just in time for April Fools’ Day.

This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level.  The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.  

On an annual basis that would be a loss of over $100 billion. Recalling the famous line of Everett Dirksen — about how a billion here and a billion there starts to add up to real money —  we are talking about serious losses. These are cash, operating losses. The mark to market of the assets in Fed’s balance sheet also caused an unrealized loss of $1.1 trillion as of September 30.  

To see the negative capital from the Fed’s weekly “H.4.1” report, one does have to do a bit of the simple arithmetic of the first paragraph. The Fed’s balance sheet claims its capital is $42 billion, but in violation of the most obvious accounting principle (from which it conveniently excepts itself), the Fed does not subtract its operating losses from its capital as negative retained earnings.

Instead, it accumulates the losses as an opaque negative liability, which balance is found in Section 6 of the report under the title “Earnings remittances due to the U.S. Treasury.” These are simply negative retained earnings: to get the right answer, you just subtract them from the stated capital.

Although the Fed itself and its defenders say that its negative capital and its losses don’t matter to a central bank, they do mean the Fed has become a fiscal drag on the American Treasury, a current cost to the taxpayers instead of a contributor of profits to it, as, just for the record, it was for more than a century.

The situation is certainly unbecoming for what is supposedly the world’s greatest central bank. Did the Fed intend to lose this much money and drive its capital negative?  I think that the answer is no. Yet the Fed seems never to have explained to Congress how big a big money-loser and fiscal drag it would become.  

The unprecedented $44 billion in operating losses so far, and their unavoidable continuation, are a feature of the post-1971 age of Nixonian fiat money, where the dollar is undefined in statute and unlinked from gold or silver specie. 

This has allowed the Fed to have, in effect, made itself into the financial equivalent of giant 1980s savings and loan. Of the Fed’s $8.7 trillion in assets, there is a risk position of about $5 trillion of long-term fixed rate investments funded by floating rate deposits and borrowings.

Of these investments, $2.6 trillion are mortgage securities made out of 30-year fixed rate mortgages.  The result is an extreme interest rate risk, which turned into big losses when interest rates rose. This interest rate risk is similar to that of Silicon Valley Bank.  

The Fed knew it was creating the interest rate risk, but seems not to have expected the massive size of the losses which resulted. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.”  

Of course, if short term interest rates had stayed near zero, the Fed would now be reporting big profits instead of big losses.  Two years ago, in March 2021, the Fed was still rapidly adding to its long term investments and to the magnitude of its risk. At that time, the Fed published projections for 2022.

In what seems unbelievable now, yet was the belief of the Fed then, the 2022 projection for the federal funds rate was 0.1 percent. The highest individual forecast was 0.6 percent.  Needless to say, the reality at the end of 2022 was a fed funds rate of 4.5 percent. 

That was how much the cost of the Fed’s floating rate liabilities went up and generated losses for it and the Treasury.  So much for Fed foresight. This provides yet another instructive lesson in how an interest rate risk position can move against you much more than you thought.

Unfortunately, with such forecasts, and with its years of suppressing interest rates and buying trillions in long term bonds and mortgage securities, the Fed was also the Pied Piper who led the banking system as a whole into a similar risk position.  

A recent National Bureau of Economic Research working paper correctly points out that for banks, the interest rate risk arises not only from long term fixed rate securities, but also from fixed rate loans.  Taking all of these into account, the paper estimates the current mark to market loss of the banking system at $2 trillion.  

All banks together have tangible capital of about $1.8 trillion.  So using the broad NBER estimates, it looks like on a mark-to-market basis, we may have a banking system with a tangible capital in the neighborhood of zero, in addition to a central bank with negative capital. What hath the Fed wrought?

Yes, taxpayers fund the Fed's losses

Published in the Washington Examiner.

Let us start with why the Fed is losing money. Paul H. Kupiec and Alex J. Pollock over at the Wall Street Journal explain in detail, but in short, the Fed purchased Treasurys and mortgage-backed securities — trillions of dollars' worth, in fact — back when they inexplicably held interest rates near zero, despite persistent economic growth. The purchase of these bonds put more money into the economy. They now pay the Fed a low interest rate, meaning they are comparatively worth less than new Treasurys that pay higher rates.

For the First Time, the Fed Is Losing Money

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to interest-rate risk exposure, the central bank will soon have negative equity capital.

Like all central banks, the Federal Reserve was designed to make money for the government from its monopoly on issuing currency. The Fed did generate profits, which it sent to the Treasury, every year from 1916 on—until last fall. In a development previously unheard of, the Federal Reserve has suffered operating losses of about $42 billion since September 2022.

That month, the massive interest-rate risk created by the Fed’s asset-liability maturity mismatch began generating cash-operating losses, and the losses now average $7 billion a month. This is because the Fed’s trillions of dollars of long-term investments yield 2% but cost 4.6% to finance. The Fed will soon have negative equity capital, and as operating losses continue to mount, its equity-capital deficit will grow.

In a July 15, 2022, note, the Fed’s Board of Governors discussed the possibility that the system could incur substantial operating losses as it increased interest rates to fight inflation. The Fed tried to play down the importance of the issue, arguing that its “mandate is neither to make profits nor to avoid losses”—a deflection that is disappointingly transparent to anyone familiar with central banking.

The Fed traditionally avoided policies that would expose it to significant losses. In the early years, member banks could borrow from reserve banks only by posting specific collateral. The Federal Reserve Act required loans to be backed by qualifying short-term self-liquidating bills—what today we call commercial paper. Over time, loan collateral requirements evolved, but as they did, the Fed introduced policies to protect it from losses when lending to member banks.

When Congress or the executive branch tapped the Fed for emergency loans to avert a wider financial crisis, it sought government guarantees to protect itself from default losses. Franklin D. Roosevelt’s administration asked the Fed to stand ready to provide loans to banks that were allowed to reopen after the 1933 national bank holiday. Instead of lending directly to these banks, the Fed proposed that it lend to the Reconstruction Finance Corp., which could then lend the proceeds to the newly reopened banks—because the RFC had an explicit federal-government guarantee that would protect the Federal Reserve system from potential losses should a newly reopened bank fail.

Similarly, the Fed’s special lending programs in response to the 2008 and 2020 financial crises were undertaken only after the Treasury allocated funds to absorb losses the Fed might incur from emergency loans. The latest Fed special lending facility, announced on March 12, also protects the Fed from lending losses. The first $25 billion of losses incurred by this new emergency program (which lends banks the par value of their underwater mortgage-backed securities and Treasurys) will be covered by the Treasury.

Avoiding credit losses is a requirement Congress added to the Federal Reserve Act in 2010. Section 1101 of the Dodd-Frank Act requires the Federal Reserve Board to establish “policies and procedures . . . designed to ensure that any emergency lending program or facility . . . protect taxpayers from losses.” Federal reserve banks are also mandated to assign “a lendable value to all collateral for a loan executed by a Federal reserve bank . . . in determining whether the loan is secured satisfactorily.”

While the Federal Reserve Act requires the Fed to avoid taking credit related losses that could have an impact on taxpayers, it makes no mention of losses from interest-rate risk exposures. The act’s authors never imagined such losses. Monetary policy was all but assured to generate Fed profits prior to 2008. That changed once the Fed started paying banks interest on their reserve balances and making large open market purchases of long-maturity Treasurys and mortgage-backed securities.

Fed losses from its interest-rate-risk exposures—unrecognized taxpayer losses—are now being realized in ways Congress never intended and at magnitudes neither the Congress nor the Fed ever expected.

Mr. Kupiec is a senior fellow at the American Enterprise Institute. Mr. Pollock is a senior fellow at the Mises Institute and a co-author of “Surprised Again! The Covid Crisis and the New Market Bubble.”

Can we regulate our way towards financial stability?

Published in the Institute of Economic Affairs:

Here a new book by Alex Pollock and Howard Adler gives the answer. The book is called Surprised Again, and for good reason. Central bankers frequently tell us that they have fixed the problems of stability this time, and then, often quite soon afterwards, they are surprised and another shock comes. 

Why is this? However clever they are, the world fools them, and always will. The explanation turns on the difference between risk and uncertainty. Risk is when we know the range of possible outcomes, and the chance of each. There are many such situations about. But there is also uncertainty – when we may not even know the full range of possible outcomes, and we certainly cannot know how likely each is. This important distinction was the subject of a book by Frank Knight in 1921, and was emphasised recently by John Kay and Mervyn King in their Radical Uncertainty. 

The distinction is at the heart of another new book by Jon Danielsson, who shows that to stabilise finance we need to think about the system as a whole. In The Illusion of Control he writes that 

“The more different the financial institutions that make up the system are and the more the authorities embrace that diversity the more stable the system becomes and the better it performs” (p. 9).  

This is an important part of the explanation for the stability of the British banking system in the nineteenth and a good part of the twentieth centuries. The names of banks – Midland Bank, Bank of Scotland, British Linen Bank for example –make one aspect of this diversity clear. 

Mises Institute's Alex Pollock discusses the The Silicon Valley Bailout

First aired on Chicago’s Morning Answer:

The Silicon Valley Bailout

Published in Law & Liberty.

In spite of the financial market losses and crashes of 2022, government agencies kept assuring us that the banking system was in good shape. Until it wasn’t. Then they were citing “systemic risk” as the reason for a bailout. Surprised again!

The Silicon Valley Bank (SVB) failed on March 10 with great fanfare, as befitted the second largest bank failure in U.S. history. It failed, it turns out, with the balance sheet mistake of borrowing very short and investing very long, a mistake so elementary as to display remarkable financial incompetence.

SVB’s failure was preceded by the collapse of Silvergate Bank, and followed by the failure of Signature Bank (the third largest bank failure), by lines of customers making withdrawals from First Republic Bank, and pressure on banks known to have large unrealized losses on their investments. As always happens in a banking crisis, the government intervened. In this case, it guaranteed the uninsured deposits at the failed banks—and presumably all banks—and created a special Federal Reserve loan facility backed by the U.S. Treasury that will lend on an under-collateralized basis to banks which have large market value losses on their bonds and mortgage-backed securities.

After SVB failed, wealthy depositors, including venture capitalists and cryptocurrency barons, presumably sophisticated financial actors, whose money was caught in the failure, immediately began begging the government for a bailout. (It is reasonable to assume that those among the begging parties who are large Silicon Valley Democratic contributors could get their calls to Washington answered.)

The SVB situation reminds us that deposits are in fact unsecured loans to the bank by another name. As everybody knows, for up to $250,000 per depositor per bank, they are guaranteed by the government. For any amount beyond that, as a lender, you are at risk, or supposed to be. If the banks fails, you become an unsecured creditor of the insolvent estate. Every big depositor in SVB knew this perfectly well. They nonetheless chose to make unsecured loans of huge amounts, in one case of $3.3 billion to one poorly managed bank. Thinking of them correctly as lenders, should sophisticated lenders who make bad loans suffer losses accordingly? Of course.

The perpetual wisdom of managing a bank was expressed by Walter Bagehot, the great financial thinker and partner in a successful private bank himself, 150 years ago. It has been re-learned to their sorrow by the banks, both failed and threatened, in recent days. Wrote Bagehot in 1873:

 A banker, dealing with the money of others, and money payable on demand, must be always, as it were, looking behind him and seeing that he has reserve enough in store if payment should be asked for…. Adventure is the life of commerce, but caution… is the life of banking.

Bagehot added that what is required is “a wise apprehensiveness, and this every trained banker is taught by the habits of his trade, and the atmosphere of his life.” But the management of SVB and other failures, perhaps too caught up in a speculative environment and too focused on public relations, did not develop sufficient apprehensiveness.

Bagehot’s insight reflects the inherent logic of bank runs. Once a bank has lost its credibility and a widespread withdrawal of deposits and other credit has begun, the holder of a non-government guaranteed deposit (an unsecured loan to the bank, as we have said) is faced with a compelling logic. To hold on and keep the deposit in the now-risky bank has zero upside. The best you can ever get is your money back. But it has a huge downside: you may suffer a big loss on funds that you supposed had minimal risk, you may have even the money you do eventually get back tied up in a receivership, you will have made yourself a first class sucker, and if you are a professional short-term money manager, you may well lose your job. In sum: zero upside, huge downside. So you take the money now. Everyone else is making the same totally rational calculation, and good-bye bank.

All the desperate statements from the bank’s management, as long as they last in their jobs, that really everything is OK, will only convince you that things must be really bad—and every plea from the government to stay calm and have confidence will confirm that your fear is justified. As Bagehot also said, “Every banker knows that if he has to prove he is worthy of credit… in fact his credit is gone.” This is now being demonstrated once again.

Every bailout means taking some people’s money and giving it to others.

“Yellen dismisses bailout” began the page one headline of the Financial Times for March 13, the Monday after the Friday closure of SVB. But by the time that issue of the paper landed in my driveway, a huge bailout had been announced.

The FT article related that “Treasury Secretary Janet Yellen…dismissed calls from some of those with money caught up in SVB to launch a full-scale bailout.” “But,” it continued, “US authorities were facing mounting calls from investors, entrepreneurs and some lawmakers to step in more forcefully to ensure all depositors were made whole.”

Of course, that “all” only meant that big depositors were to made whole, since those with claims up to the quite respectable amount of $250,000 were guaranteed already. The $250,000 obviously covered all the widows and orphans and anybody of modest means. These are the people who proponents of government deposit guarantees always argue are unsophisticated and cannot understand how a bank works, so need to be unconditionally protected. But they already were. So the actual issue was bailing out very sophisticated venture capitalists, cryptocurrency promoters, and various billionaires, all of whom were quite capable of understanding the nature and risks of banking in the SVB fashion.

Should such sophisticated lenders to banks be bailed out from their own financial mistakes?

One partner of a Silicon Valley venture capital firm wrote in this context, “I’m sure many will look upon [SVB’s] demise…and chuckle gleefully about how the technology industry just got a spanking. So be it. We are not seeking special treatment or handouts.”

But they were seeking very special treatment and a very big handout: the government giving them in immediate cash 100% of their uninsured claims on a failed bank receivership. And they got the handout. Whether one was surprised or not by this is perhaps a measure on one’s cynicism.

It is easy for cynics to imagine the calls from the wealthy uninsured depositors and their agents with the U.S. Treasury, the Federal Reserve and the White House. Naturally, internet posts were soon talking of political favors to Silicon Valley Democratic contributors.

As my colleague, Benjamin Zycher, considered the matter:

Now that the bailout of the SVB depositors at 100 percent rather than the nominal $250,000 limit has been announced, it is difficult to discern whether the primary motivation is avoidance of future bank runs… or an old-fashioned effort to reward the wealthy friends of the Democratic Party in Silicon Valley.

As Ben suggests, it is probably both.

Every bailout means taking some people’s money and giving it to others. President Biden has claimed that this bailout does not involve taxpayer money. To the contrary, it makes the U.S. Treasury, in other words the taxpayers, first in line to take losses on the under-collateralized loans the Federal Reserve will make to banks under the bailout plan. Every such bailout tends to encourage risk taking and a lack of wise apprehensiveness in the next cycle.

Meanwhile, losses to the Federal Deposit Insurance Corporation from the bailout of the SVB’s wealthy depositors will be assessed on all other banks. That still means taking money from other people to give to the big SVB depositors. So a small, sound, careful bank in, say, small town Wisconsin, will have money taken from it to give to the California venture capitalists, crypto barons, and billionaires, to cover their losses from the incompetence of the Silicon Valley Bank. That is the idea. How do you like it?

The ‘Insolvency’ of the Fed

Published in the New York Sun:

“A bad balance sheet killed Silicon Valley Bank,” Mr. Coy writes. “You know what other bank has a similar balance sheet?” he asks. “The Federal Reserve,” is the reply. An ex-Treasury official, Alex Pollock, goes further, telling us the Fed’s balance sheet “looks just like a Savings & Loan in 1980.” It echoes the worst banking crisis since the Depression. It’s a reminder that while we may be in a banking crisis, the real emergency is fiat money.

It was abandoning the gold standard, after all, that allowed central banks like the Fed to veer into monetary experiments like its Quantitative Easing, buying up trillions in assets while keeping interest rates artificially low. Now that rates are rising, a reckoning is at hand. The Fed’s QE assets “yield 2 percent or 3 percent, but the cost of funding them is now over 4 ½ percent,” Mr. Pollock notes — “a guaranteed way to lose money.” 

…

Mr. Pollock, who directed financial research at Treasury, sums up the Fed’s view as “It doesn’t matter and no one cares.” There may be some truth to this, given the deference the press shows the Fed and the Fed’s own obfuscation of its work via the PhD-inflected language known as FedSpeak. Yet the bank runs could raise scrutiny on the Fed. Asked how Silicon Valley Bank’s balance sheet compares to the Fed’s, Mr. Pollock says “it’s worse.” 

How Should We Regulate Crypto?

Published by David G.W. Birch:

Meanwhile, Howard Adler, a former deputy assistant secretary of the Treasury for the Financial Stability Oversight Council, and Alex Pollock, a former Principal Deputy Director of the Treasury’s Office of Financial Research, advocate a more laissez-faire approach: Why regulate crypto at all?Their view is that we should allow investors to proceed at their own risk under the protections of general commercial law and existing anti-fraud and criminal laws. As they point out, since cryptocurrency originated as a libertarian revolt against the government monopoly on money, this approach is consistent with its founding ideas.

How the Fed’s 2008 mortgage experiment fueled today’s housing crisis

Published in The Hill with Paul H. Kupiec.

How should Congress assess the Federal Reserve’s track record as an investor in residential mortgage-backed securities (MBS)?  Regardless of Fed spin, it merits a failing grade. 

The Fed’s COVID-era intervention in the mortgage markets fueled the second real estate bubble of the 21st century. The bubble ended when the Fed stopped purchasing MBS and raised rates to fight inflation. While time will tell whether recent increases in home prices are reversed, the end of the bubble has already cost the Fed over $400 billion in losses on its MBS investments.

From 1913 until 2008, the Fed owned precisely zero mortgage-backed securities. While the Fed’s monetary policy decisions still impacted conditions in the housing and mortgage markets, they did so indirectly through the influence the Fed’s purchases and sales of Treasury securities had on market interest rates. 

In a radical “temporary” policy response to the 2008 financial crisis, the Fed began intervening directly in the mortgage market. Through a series of MBS purchases, the Fed’s MBS portfolio ballooned from $0 to $1.77 trillion by August 2017. The Fed subsequently altered policy and slowly reduced its MBS holdings. By March 2020, it held about $1.4 trillion in MBS.

When the COVID crisis hit in March 2020, the Fed decided to reinstate its 2008 financial crisis rescue plan. It resumed purchasing MBS as well as Treasury notes and bonds. By the time it stopped its purchases in the spring of 2022, it owned $2.7 trillion in MBS. The Fed had become the largest investor in MBS in the world. By spring 2022, it owned nearly 22 percent of all 1-to-4 family residential mortgages in the U.S. By Sept. 30, the date of the last available quarterly Fed consolidated financial statement, the Fed had lost $438 billion on its MBS investments. These losses will increase if the fight to subdue inflation requires still higher interest rates.

Because most buyers borrow 80 percent or more of the purchase price of a home, house prices are sensitive to the level of mortgage interest rates. Low mortgage rates increase the pool of potential buyers, stimulating housing demand. If the interest rate stimulus is overdone, excess demand will push up home prices. High mortgage interest rates have the opposite effect. They dampen demand, dissipate upward pressure on home prices, and in some cases, lead to home price declines. 

As one might predict, the Fed’s massive MBS purchases coincided with large reductions in mortgage interest rates. During the Fed’s COVID MBS purchase campaign, the national average 30-year mortgage interest rate fell to a low of 2.65 percent in January of 2021. Today, with the Fed’s campaign of higher interest rates to battle inflation, 30-year mortgage interest rates are hovering around 7 percent. This change in the mortgage interest rate alone would cause monthly principal and interest payments on a same-sized mortgage loan to increase by 65 percent.

Predictably, the decline in mortgage interest rates stimulated housing demand and pushed up home prices. Government statistics report that, from January 2018 to this January, the median new home price in the United States rose from $331,800 to $467,700 — an increase of 41 percent. Interestingly, from January 2018 through March 2020, before the Fed renewed its MBS purchases, the median price of a new house actually declined to $322,600. From April onwards, the national median house price rose steadily, reaching a peak of $468,700 by the end of June 2022.

In 2018, purchasing a new median-price home with 20 percent down and the then prevailing average 30-year mortgage rate of 3.95 percent required $1,259 in monthly principal and interest payments. In January, purchasing the $467,700 median-priced new home with 20 percent down required monthly payments of $2,360 given the 6.48 percent rate on a 30-year mortgage. In only 5 years, because of house price inflation and higher mortgage interest rates, the monthly principal and interest payment needed to purchase a median-priced new house increased by 87 percent!   

The Fed’s foray into the MBS market will have a long-lasting impact on real estate markets. Not only has demand for homes been softened by home price inflation and 7 percent mortgage rates, but current homeowners with favorable mortgage interest rates are reluctant to sell, reducing the inventory of homes available for sale in a market that is already starved for listings. This unfavorable balance is clearly reflected in the National Association of Realtors housing affordability index which has fallen from a cyclic high of 180 in July 2021, to recent readings below 100, indicating affordability challenges not seen since the double-digit mortgage interest rates of the 1980s.

The end of Fed MBS purchases and the increase in Fed policy rates have put an end to the COVID housing bubble. While home prices are showing declines in some areas, prices in other areas remain elevated due to historically low inventories of homes for sale and strong job markets.

Any realistic review of the impact of the Federal Reserve’s experiment investing in MBS would conclude that the Fed should stop buying mortgages. Its decision to invest trillions of dollars in MBS has helped to push the cost of home ownership beyond the reach of many. Others will find themselves locked into homes they cannot afford to sell because of the artificially low rates on their current mortgages. 

From either perspective, the Fed’s MBS experiment has whipsawed housing markets and cost the Fed over $400 billion in MBS losses. It’s hard to see how this experiment merits anything but a failing grade.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute.  Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again!—The Covid Crisis and the New Market Bubble.” 

WRAL: Fact check: Has the U.S. ever defaulted on its debt?

From WRAL:

Possible precedents for defaults

In a 2021 op-ed in The Hill, a political news outlet, Alex J. Pollock, a former Treasury Department official, argued that there are four precedents for U.S. defaults. Pollock cited cases of the U.S. Treasury: Resorting to paper money largely not supported by gold during the Civil War in 1862; Redeeming gold bonds with paper money rather than gold coins during the Great Depression in 1933; Not honoring silver certificates with an exchange of silver dollars in 1968; and Abandoning the Bretton Woods Agreement in 1971, which included a commitment to redeem dollars held by foreign governments for gold. Also, a 2016 analysis by the nonpartisan Congressional Research Service noted that in 1979, the Treasury failed to make on-time payments to some small investors because of technical glitches. Most were paid within days or a week. The research service concluded that although the temporary payment delays "inconvenienced many investors, the stability of the wider market in Treasury securities was never at risk." But multiple economic specialists agree that although these were notable episodes, they do not mirror the type of default to which Jeffries was referring.

FHLBs—Mission and Possible Improvements

Based on long experience and extensive study of various systems of housing finance and of financial systems generally, I respectfully offer the following thoughts on the mission of and possible improvements in the Federal Home Loan Banks (FHLBs).

Mission

I think the mission of the FHLBs is to support, in key words of the Federal Home Loan Bank Act, “sound and economical home finance,” by linking sound home finance nationwide to the bond market.  FHLBs’ principal activities should always be clearly tied to this mission, which should benefit tens of millions of mortgage borrowers throughout the country.

FHLB member institutions should be those which provide sound and economical home finance.  As markets evolve over time, which types of institutions are eligible membership should adapt to appropriately reflect this evolution.  For example, as commercial banks, originally excluded from FHLB membership, largely supplanted savings and loans in home finance, they were logically made eligible for FHLB membership by the Financial Institutions Reform, Recovery and Enforcement Act of 1989.

In my view, the FHLBs should take minimum credit risk, and all the credit risk of the mortgages they link to the bond market should be borne in the first place by the FHLB member financial institutions.  This is true of both FHLB advances, in which all the underlying assets stay on the books of the member, and for the fundamental concept of the FHLB Mortgage Partnership Finance program, in which the mortgage loan moves, but a permanent credit risk “skin in the game” stays for the life of the loan with the member institution, where it belongs.  Note that this is the opposite of selling loans to Fannie Mae and Freddie Mac, in which the lending institution divests the credit risk of its own customer that results from its own credit decision.

Since the mission of the FHLBs is sound and economical home finance, their subsidizing affordable housing projects is secondary. In an economic perspective, these programs may be seen as a tax on the FHLBs, and in a political perspective, a tactic which allows members of Congress the convenience of creating subsidies without having to approve or appropriate the expenditures.

FHLBs without doubt have important benefits from their government sponsorship.  These benefits should primarily go to supporting sound and economical home finance provided by member institutions throughout the country.  To assert that all or most of these benefits must go to subsidizing affordable housing is obviously disproportionate.

In the “mission” discussions, we can usefully distinguish between two groups of FHLB beneficiaries.  First are those who have also have skin in the game through having put their own money at risk by capitalizing, funding or financially backing FHLB operations.  They are the stockholder-members, the bondholders, and the U.S. Treasury.  Second are those who only receive subsidies from the FHLBs.

Suggested Improvements

1. The FHLBs should be given the formal power to issue mortgage-backed securities, provided these securities are always designed so that serious credit risk skin in the game remains with the member institutions.  This would give the FHLBs a very important additional method to carry out their mission and would be a long-overdue catching up with financial market evolution.

2. The Federal Home Loan Bank Act should be amended specifically to authorize the FHLBs to form a joint subsidiary to carry out functions best provided on a combined, national basis.  The participating FHLBs should own 100% of this joint subsidiary.  This addition to the FHLB Act is needed because of the requirements of the Government Corporations Control Act of 1945, when the U.S. Treasury still owned some FHLB stock.  It has not owned any for 70 years, but the 1945 statutory requirement is still there.

3. The prohibition of captive insurance companies from being FHLB members should be promptly withdrawn.  In my view, this was not only a mistake, but inconsistent with the FHLB Act, which has provided from July 1932 to today that “insurance companies” in general, with no distinctions among them, are eligible for FHLB membership.  I believe to change that required Congressional action, which was not taken.  Any insurance company, including a captive insurance company, which provides sound and economical home finance should be eligible for FHLB membership.

I hope these ideas will be helpful for the ongoing success of the FHLBs.

Alex J. Pollock is a Senior Fellow of the Mises Institute and co-author of the new book, Surprised Again!—The Covid Crisis and the New Market Bubble.  He was previously president and CEO of the Chicago FHLB, president of the International Union for Housing Finance, and Principal Deputy Director of the U.S. Office of Financial Research.

The Fed's Capital Is Rapidly Heading to Zero, and Below

Published in RealClear Markets.

Since September 2022, the Federal Reserve has lost about $36 billion.  A big number!—and notably big compared to the Fed’s stated capital of $42 billion. Thus the Fed has already run through about 85% of its capital and has only $6.6 billion (0.07 % of its total assets) left as of February 22. How long will it take to burn through that?  Less than three weeks.

So the Fed’s real capital will hit zero in mid-March. By April Fools’ Day, it will be proceeding into ever more negative territory.

What does negative capital mean for the world’s top central bank?  As for any entity, it means that its liabilities exceed its assets, and that it is technically insolvent.

Here we are dealing with the Fed’s real capital, in contrast to the stated capital its financial statements report.  For every organization, everywhere and necessarily, losses reduce retained earnings and thus total capital.  Nothing could be more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses of $36 billion. But the Fed wishes to exempt itself from this law of accounting, by treating its losses as an asset, which they aren’t.  It wishes us to believe that if it loses $100 billion, as it probably will in 2023, or $200 billion, or even $1 trillion, that its capital would always be the same.  “LOL,” as people text these days. The situation may make you think of the cynically realistic remark of Jean-Claude Juncker, when he was the head of the European finance ministers: “When it becomes serious, you have to lie.”

The Fed itself and most economists claim about the losses and the looming negative capital that “It doesn’t matter and no one cares.” They point out that the Fed can continue to print up more money to pay its obligations, no matter how much it has lost or how much less its assets are than its liabilities.  

Nonetheless, it is surely embarrassing to have lost all your capital, let alone twice or three times your capital, as the Fed will have done by the end of this year.  Whether it did this intentionally or unintentionally, it raises pointed questions about whether the Fed correctly anticipated such huge losses and how negative its capital would become, and, if it did, whether it informed Congress of what was coming.

A second argument the Fed and its supporters make is that “Central banks are not supposed to make profits.”  This is not correct.  All central banks, including the Fed, are designed precisely to make profits for the government through their currency monopoly.  They issue non-interest bearing currency, and make interest bearing investments.  This makes profits automatically and thereby reduces the Treasury’s deficit.  But no more.  The easy profits have been wiped out by the losses on the Fed’s $5 trillion risk position of investing long and borrowing short, now upside down.  The Fed has trillions of long-term “Quantitative Easing” investments it bought to yield 2% or 3 %, but the cost of funding them is now over 4 1/2%-- a guaranteed way to lose money.  And the Fed’s borrowing costs are likely headed still higher, making its losses still bigger. 

Thus the losses are the actualization of the immense financial risk the Fed knowingly took, while not knowing how bad the outcome would be.  The Fed’s losses now make its capital negative, increase the federal deficit and are a fiscal burden on the Treasury.

The Fed is not alone in this problem, since many central banks together set themselves up for losses. “Euro Area Braces for Era of Central-Bank Losses After QE Binge,” in the words of a recent Bloomberg headline. In Great Britain, His Majesty’s Treasury has committed to pay for losses of the Bank of England, and the Canadian Finance Ministry has entered into a contract with the Bank of Canada to offset any realized losses on the Bank’s QE bonds.  

Should the U.S. Treasury recapitalize the Fed by buying stock in the Federal Reserve Banks?  Unlike in most other countries, the U.S. government does not own the stock of its central bank— private banks do.  The Fed does have a formal call on the private banks to require them to buy more stock-- the half of their stock subscription they have not paid in.  This would raise about $36 billion in new capital.

But the Fed certainly does not want to be seen as needing to call this additional capital-- or needing to skip its dividend, as both the European Central Bank and the Swiss central bank have done this year.

Nor does the Fed wish its balance sheet to show its real capital.  But if, as the Fed argues, it doesn’t matter and no one cares, why go through the charade?  Why not simply report the true number?

Hemorrhaging losses, the Fed’s problems are now the taxpayer’s

Published in The Hill with Paul H. Kupiec.

When liabilities exceed assets, equity capital is negative and an entity is technically insolvent. Few institutions in that condition can continue operating at a loss indefinitely, and those that can usually benefit from an explicit government guarantee. Past special cases have included government-backed agencies like the U.S. housing GSEs. 

From mid-March 2023, there will be a new addition to the list of institutions that, while losing billions of dollars a month and technically insolvent, with the benefit of taxpayer support will still be able to issue billions in new interest-bearing liabilities. That institution is the Federal Reserve.

With large projected operating losses and liabilities already in excess of assets, existing creditors are unlikely to be repaid, let alone new creditors. No sensible fiduciary would lend under these conditions unless newly injected funds have seniority in bankruptcy or carry an explicit government guarantee.

Since mid-September, the Federal Reserve has lost about $36 billion and will continue to post billions of dollars a month in losses for many months if not years to come. Fed losses have already consumed about 85 percent of its stated capital of $42 billion. It will take less than 3 weeks for the Fed to burn through the $6.6 billion of its remaining capital. 

The Fed routinely creates new money by purchasing interest-bearing U.S. Treasury securities in exchange for newly created Federal Reserve notes or interest-bearing bank reserves. From mid-March on, the Fed will, for the first time in its history, pay for its accumulating losses by issuing new liabilities without acquiring any new interest-bearing assets. The Fed will pay its bills by printing new money — not just Federal Reserve Notes that pay no interest, but by issuing new reserve balances that pay banks an interest rate higher than can be earned in a savings account.

When the housing GSEs were insolvent and losing money hand-over-fist, the U.S. Treasury used congressional powers in the Housing and Economic Recovery Act of 2008 to inject enough new capital to save the GSEs from defaulting so they could continue to borrow and operate. How can a technically insolvent and loss-hemorrhaging Federal Reserve continue to operate without a similar congressionally-approved bail-out?  Do other central banks have the Fed’s seemingly magical power to continue operations while technically insolvent, and yet still issue billions in new interest-bearing liabilities to cover losses?

The “magic” begins with the fact that, regardless of the size of its accumulated losses, the Fed will always report positive equity capital. By any sensible accounting standard, losses reduce retained earnings and capital. Nothing is more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses. The Fed magically suspends this law of accounting by booking its accumulated losses as an asset. If Fed losses accumulate to $100 billion, as they probably will in 2023, or to $200 billion or more by 2024, the Fed will report that it still has $42 billion in equity capital. Magic.

The Fed and many economists believe that the Fed’s losses and its looming negative capital position are inconsequential. While other central banks shrug-off losses, they are not so cavalier with their accounting treatment of losses, nor do they contend that their capital position is of no consequence.

In reporting its recent losses, the European Central Bank canceled paying dividends and was careful to state that its losses were well covered by its reserves and so had no impact on its capital. The Swiss National Bank’s $143 billion loss in 2022 caused it to cancel its dividend payments and reduce its retained earnings. It still remains well-capitalized by central bank standards. In Great Britain, His Majesty’s Treasury explicitly agreed to offset losses of the Bank of England, and the Canadian Finance Ministry has a contract with the Bank of Canada to offset any realized losses on its QE bonds. Meanwhile, the Dutch central bank alerted its country’s Treasury of the possibility that the bank might need to be recapitalized. For all of these central banks, their equity capital position apparently does matter.

With negative real capital and massive losses accruing, how will the Fed still pay member banks a dividend, interest on their reserves balances, conduct monetary policy and pay its bills? With the benefit of an implicit government guarantee — a guarantee that has so far avoided any mention in congressional hearings.

On a consolidated government basis, the Fed’s accounting treatment — paying for accumulating losses by creating new interest-bearing liabilities — is equivalent to the U.S. Treasury selling new interest-bearing debt and remitting the proceeds to the Fed to cover its losses. If Fed losses were paid and accounted for in this way, the Fed’s losses would count against the Federal budget deficit and the new Treasury debt issued would add to the Federal government’s outstanding debt.

With the Fed counting its accumulating losses as a deferred asset, the losses do not reduce the Fed’s reported equity capital or increase the federal budget deficit. Moreover, the new interest-bearing liabilities the Fed issues to pay bank dividends, interest on bank reserves and to cover other Fed operating costs do not count as part of the U.S. Treasury’s outstanding debt.

The Fed’s accounting trickery allows the Fed to borrow taxpayer money to cover its losses without the borrowing or the losses appearing on the Federal government’s ledgers. The Fed itself decides how much to borrow from taxpayers without any explicit congressional authorization. The current arrangement inadvertently allows the Fed to appropriate, borrow and spend taxpayer dollars on its own authority — an issue that should be addressed in the Fed’s next semi-annual congressional appearance.

The Government Debt Ceiling: What Did Eisenhower Do?

July 27, 2011

Published with Anne C. Canfield in AEIdeas.

“Nothing is ever new, it is just history repeating itself”—at least in finance. In his A History of the Federal Reserve,¹ Allan Meltzer describes what happened during the Eisenhower administration when the Treasury ran out of debt authorization and Congress did not raise the debt ceiling. This was in 1953.

In order to keep making payments, the Treasury increased its gold certificate deposits at the Federal Reserve, which it could do from its dollar “profits” because the price of gold in dollars had risen. The Fed then credited the Treasury’s account with them, thereby increasing the Treasury’s cash balance. Treasury then spent the money without exceeding the debt limit.

By the spring of 1954, Congress had raised the debt ceiling from $275 to $280 billion (2 percent or so of today’s limit), so ordinary debt issuance could continue.

The Secretary of the Treasury still is authorized to issue gold certificates to the Federal Reserve Banks, which will then credit the Treasury’s cash account.² This is correctly characterized as monetizing the Treasury’s gold, of which it owns more than 8,000 tons. An old law says this gold is worth 42 and 2/9 dollars per ounce, but we know the actual market value is about 38 times that, at more than $1,600 per ounce.

Should we follow Eisenhower’s example?

Alex J. Pollock is a resident fellow at the American Enterprise Institute.  Anne Canfield is president of Canfield & Associates, Washington, D.C.

1. Allan Meltzer, A History of the Federal Reserve, Volume 2, Book 1, pp. 110 and 168.

2. Federal Reserve Bank of New York, 2010 Annual Report, p. 39.